Can the Hedge Fund ETF Actually Deliver?

By Matthew Hougan

The new IndexIQ Hedge Fund ETF (QAI) is one of the most interesting - and controversial - ETFs to launch in a while.

The fund, which aims to synthetically replicate the performance of hedge fund strategies, launched Wednesday on NYSE Arca. Judging by early trading volume, the new fund is going to be a hit: QAI looks like it will trade more than 100,000 shares today (Thursday), an impressive performance for just its second day on the market.

The idea of providing access to hedge fund-like returns through an ETF is hugely attractive. The best investors in the world—endowments like Harvard and Yale—hold enormous investments in hedge funds for a reason: They deliver returns with low correlations to the broader market. If QAI can make those returns available to all investors in a low-cost wrapper, it'll be big news.

As I said yesterday on CNBC, however, the proof will be in the pudding: Can QAI actually deliver on its promises?

It's important to understand that this ETF doesn't actually invest in hedge funds; rather, it uses factor-based analysis to determine the performance characteristics of hedge funds in general, and then builds a portfolio (using other ETFs) that it thinks will replicate that performance.

Over the past few days, a lot of people have told me that this idea sounds crazy. I disagree. Too many people have a near-mythical conception of hedge funds; they think they are run by high-paid geniuses who make either spectacular or spectacularly bad investments. The truth is more mundane: While some hedge funds are run by geniuses, most are run by normal guys who use pretty standard strategies to generate a certain kind of return. They do a reasonable job, and are paid absurdly well to do it.

The idea of synthetically replicating that performance at lower costs is well-established both in academia and the real world. Both Goldman Sachs (GS), and IndexIQ itself, for example, have been running synthetic hedge fund mutual funds since last summer. Generally speaking, they've done pretty well: The Goldman Sachs fund is down about 15% since July 2008, while the IndexIQ fund is down about 12%; that compares to the S&P 500, which is down about 38%. That's a good relative performance. Most hedge funds are down over that span too, in line with the synthetic products.

The question now is whether these funds will be able to perform well as the market recovers. Although both funds have well-documented methodologies, they are nonetheless largely black box strategies; the concept behind the funds make sense, but you have to have faith that the quant-engine driving them is going to work.

One advantage of the new ETF is that you can watch the holdings on a daily basis and see for yourself if they make sense. As of Wednesday's close, here's what QAI was holding:

LONG			INVERSE
Fund	Ticker	Weight	Fund	Ticker	Weight
iShares Barclays Aggregate Bond	AGG	23.89	ProShares UltraShort Russell 2000	TWM	1.93
iShares Barclays 1-3 Year Treasury Bond	SHY	18.32	ProShares UltraShort MSCI EAFE	EFU	1.62
iShares MSCI Emerging Markets Index	EEM	11.11	ProShares UltraShort Real Estate	SRS	0.46
Vanguard Total Bond Market ETF	BND	8.39	ProShares UltraShort Euro	EUO	0.4
PowerShares DB Currency Harvest	DBV	7.94
iShares iBoxx $ High Yield Corp Bond	HYG	7.29
iShares Barclays Short Treasury Bond	SHV	3.92
SPDR Barclays High Yield Bond ETF	JNK	3.25
Vanguard Short-Term Bond ETF	BSV	3.11
SPDR Barclays 1-3 Month T-Bill ETF	BIL	2.36
Vanguard Emerging Market ETF	VWO	2.22
iShares Barclays TIPS Bond	TIP	1.81
PowerShares DB Commodity Index	DBC	1.53
SPDR Barclays Capital Aggregate	LAG	0.45

If you drill down, the portfolio is fairly simple. The fund's positions include:

• 72.79% fixed income, including 32.73% in broad-based bond indexes; 27.71% in short-term Treasuries; 10.54% in junk bonds; and 1.81% in TIPS
• 13.33% in emerging market stocks, the only long equity position in the portfolio
• 9.47% in commodities and currencies
• 4.41% in various inverse funds

That's a fairly defensive portfolio. The question is, how will this portfolio perform if the market recovers? How will it adapt and change over time?

It's worth watching.

Original post

• More on choosing the right ETF

Comments

[DM226:]

Thanks Tom. We get it.

Mar 27 10:15 AM

[Drew Arnold:]

I agree, I'm surprised by how defensive this portfolio is. Maybe it's simulating a very conservative hedge fund? Or maybe they don't want the ETF to get a bad name right after its launch by experiencing immediate sizable losses...

Mar 27 10:15 AM

[brocilybeef:]

Thanks Tom for all of your posts!

Mar 27 10:19 AM

[Mad Hedge F...:]

They're obviously jumping on the bandwagon. Exchange traded funds, or ETF’s, were one of the hot financial products of 2008, and enable investors to go 100% or 200% long or short any number of indexes, sub indexes, industry groups, bonds, currencies, and commodities. The largest issuers have been Barclay’s iShares, State Street’s StreetTracks SPDR’s, Rydex, and PowerShares. Sponsors of ETF’s have filed for registration of another 850 such products, including ETF’s for many new single country funds for Columbia, Egypt, Argentina, Peru, and the Nordic countries. Charles Schwab (SCHW) has also announced that it is entering this field for the first time. These will allow fund managers to make more narrow and specific bets in the capital markets. But they will also increase market volatility, as they obviously did last year.

Mar 27 11:20 AM

[jswede:]

not nearly enough leverage... ;)

Mar 27 11:36 AM

[Steve in TN:]

All I want (need) is the current allocation of John Paulson's hedge fund.
He was up 38% in '08; shorting the market and betting against subprime mortgages.

Mar 27 12:03 PM

[Harry Tuttle:]

The idea is that a factor model, based in the past, can predict the future?

Good luck with that!

Mar 27 12:18 PM

[kdub:]

I don't get it... I thought the whole point of a hedge fund was to get returns that do not correlate to an index. When I see that this fund returned -12%... why compare it to the S&P? Instead, lets compare it to my mattress, which returns 0%.

Mar 27 12:33 PM

[GeminiAtlas:]

That makes me wonder if they could create a Venture Capital fund ETF. That would be interesting. They currently have clean energy ETFs, etc. but I would want to get in pre-IPO stage or even in the angel investment stage. I don't have the "pull" now to get into VC funds but it would be nice to get in a synthetic version, or even an ETF which invests in multiple VC funds directly.

Mar 27 01:07 PM

[krwharton:]

Why is there no Dividend on it if it is in 70+ percent bonds?

Mar 27 01:09 PM

[Fozzie:]

Factor based analysis doesn't really work, it essentially developes a static and backward looking explanation for past returns and then tries to apply it (statically, again...) to a dynamic market. Try driving forward while looking thru the rearview mirror. Or think of it this way, you are extracting all the factors that you hope aren't driving hedge fund returns, and creating a fund from them, while ignoring a large part of the manager's skill.

Mar 27 04:27 PM

[Jason S.:]

well said kdub.

Mar 27 05:24 PM

[Johnni:]

I see this as a first generation replication product, and as such deserves to get credit for starting a new type of niche ETF strategies.
Whether this one will have commercial success remains to be seen, for my part I don’t like they only identify factors once a year and then regress and rebalance among these once a month.
Ofcause there will be no alpha, but it will also have to be very static beta to be captured. I really hope they will get enough AUM to attract others within this field, and we will soon see serious near-realtime beta replication of individual HF sub-strategies at a fee of 0.75%.

Good weekend!
Johnni
johnninielsen.wordpres.../

Mar 28 08:57 AM

[User 366480:]

This allocation does not "replicate" a hedge fund strategy, if they said for example we use ETF's to execute a trend following strategy along with a long-short strategy, along with a global macro strategy and a value investing strategy , that would be different. But then again that would require talent, or talents rather. As it appears, this is just a diversified portfolio of ETF's . I am bit skeptical .

Mar 28 11:50 AM

[The Kansan:]

How about a matress tracking ETF?

Mar 28 12:51 PM

[rockstar98:]

this fund is basically long bonds with a little bit of emerging markets equities and commodities thrown in (the latter two are highly correlated anyways as much of emerging markets' economies and markets are driven by commodities companies/industries)... it's not clear to me what value a 4% position in short ETFs provides...

my point is that far from being a "hedge fund" proxy, this is just a conservative long fund with an asset allocation of that is mostly bonds... an investor can take the same money they could have put into QAI and buy 73% the total bond market index, 13% the emerging markets index, and 9% the commodities/metals fund, and probably get performance that's not too far off from what QAI will deliver...

what does QAI charge for fees?

Mar 28 03:15 PM

[Robert Mcdo...:]

Hedge funds should look again at the risk/reward of financing big banks' 'funding gaps' by buying MT Notes and Covered Bonds at good interbank rates when the Fed Rate is so low and inflation is heading down. The banks are generating enough internal capital despite continuing loss provisions and write-downs to be sound payers. The returns are respectable and at least positive.
The macro-funds are feeling really bullish however for vulture fund strategies and leveraging The Fed and FDIC or surfing off the back of the Geithner Plan deals to seek 17-25% returns on the banks' fire-sales? The deals look so good some banks would wish they were on the buyer side not the forced seller side. I bet some banks would produce good margin private deals for asset swap repos in support of medium term financing for their 'funding gaps'. Hedge funds should think longer term about relationship building with the banks and not overtly exploiting the banks' current embarassments. When recovery returns the hedgies will want positive relationships with the big banks to leverage off.

Mar 28 04:11 PM

[mrbill:]

What?

On Mar 27 09:44 AM Tom Schumacher wrote:

> I think the jury is still out on these hedge fund replication strategies.
> A fund investing in mostly fixed income should outperform an equity
> index. Is that really a surprise? So we have to pay 75 bps to get
> "factor-based analysis" which is really just a highly diversified
> portfolio. I can replicate a portfolio with 75% Fixed Income using
> ETFs for free.
>
> Search the universe of ETFs and CEF: etfdesk.com

Mar 30 03:15 AM

[mrbill:]

Maybe this is the fund that's going buy up all those toxic assets? Better keep on eye on those allocations. Before you know it, it will be 100% allocated to Fannie/Freddie and a bunch OTC REITs. Not to mention double long dollar and long TLT. And to make it look like a hedge fund, short SRS.

Mar 30 03:33 AM

[Steve Selengut:]

Hedge Fund ETFs: Under The Radar Wall Street Con

The other day, with the market giving up about a third of its March gain in DJIA points, I went looking through my favorite market stats to see if any remaining profits could be pounced upon. Typically, profit possibilities can be identified quickly on NYSE lists of the largest dollar and percent gainers.

Alarmingly, 75% of the largest percent gainers were ETFs, and many of those operate using the same strategies as classic hedge funds--- most owned no common stock at all! At the same time, 93% of the largest dollar gainers were ETFs with a large proportion plainly operating like a hedge fund.

Earlier in March, while we were all sunning ourselves in the far-too-infrequent-lately UVs of a brief rally, I was doing a similar search for undervalued IGVSI stocks. Yes, Virginia, there is an equally impressive array of hedge funds betting that the markets (and the South) actually will rise again.

What is a hedge fund, and just what does it try to accomplish? I think the key legal element is that they don't say how they intend to get the job done.

Initially, hedging was used as a risk mollifier in the securities markets in the same way as insurance is used for protection against disasters impacting life, health, and personal property. Taking a short position on an owned security, for example, protects an investor's profit if the company's market price plunges.

Naked shorting, shorting baskets of securities, and shorting indices, however, have morphed into a risk creator, not a risk reducer. Similarly, hedge funds that hold index funds as betting devices on market sector performance are not what the investment gods envisioned when they blessed the sector experiment.

The new definition of hedge fund speaks of an aggressively managed entity that uses leverage, long, short, options, futures, and derivative positions with the goal of generating high returns. Risk reduction is no longer the objective.

Hedge funds have never been regulated like their open-end mutual fund cousins--- the rationale being that they cater to a wealthy and sophisticated clientele. In fact, the law requires that participants in hedge funds jump over income, net worth, and investment high-hurdles before being eligible to participate.

Investopedia refers to them as mutual funds for the super rich, but the only similarities to the plain vanilla equity mutual fund are the pooling of participants' money and professional management. During the past decade, a series of ill advised and shortsighted rules changes gave hedge fund managers destructive powers that exacerbated the financial crisis that will mourn its second anniversary this summer.

But regulating the hedge fund is clearly a too late closing of a barn door encrusted with diamonds (no pun intended). A few years ago, the masters of the universe rediscovered, redefined, and complicated the world of closed end mutual funds by creating many different forms of passively managed index/hedge funds.

As innocent as these funds may appear, they too have altered the investment landscape. Speculators (not investors) place their bets on the rise or fall of the index. These bets artificially impact the market price of securities because many (if not all) of the funds actually own the securities they are tracking.

Additionally, many individual stocks fall into several indices, and most of the major ETF marketing companies sell similar index funds. Didn't we just go through this with mortgage-backed securities? Aren't these funds artificially taking common stock pricing further and further away from the fundamentals of the companies themselves?

Today, it appears that every passive fund has two or three accompanying short/bear ETFs plus an equal number of bull/long funds to choose from.
Apparently, the SEC has not taken the trouble to look inside the thousands of boutique ETFs that by now must outnumber the securities they are tracking.

Wall Street wants all CEFs (index, hedge, bond, equity, real estate, whatever) to be regulated and reported upon as though they were simply common stocks. As a whole, they aren't even close. In fact, there are more of these derivatives traded on the NYSE than common stocks and preferred stocks combined.

And the real crime is this: investors as naive as the wet-diapered E-Trade spokesbaby can push a button and buy operational hedge funds more bizarre and sophisticated than any ever imagined buy the rich and famous.

If an ETF harbors a hedge fund, but doesn't call it a hedge fund, is it really not a hedge fund? If Merrill Lynch creates a mutual fund with pro rata individual account statements, is it any less of a mutual fund? Is it really individual account management? Have the commissions really disappeared? The SEC thought so.

Shouldn't the regulators be smart enough (and brave enough) to put an end to these legal-in-name-only frauds? Should your mother's IRA be speculating in puts on Netherlands Tulip Bulb futures? How about 200% of the inverse of the Financial Select Sector Index?

A search at ETF-Connect for US Equity ETFs finds roughly 500 potential speculations that absolutely anyone can buy into. All are self-directed IRA eligible--- 401(k) eligible, possibly. A look inside reveals hedge-fund-like operations. But technically, they are not hedge funds because they describe the strategies employed.

So long as we tolerate Wall Street attorneys circumventing the intent of our securities laws, and so long as we reward regulators for their blind worship of the letter of these laws, we will have this kind of manipulation.

Index ETFs (and the no doubt about it hedge fund casinos they front) need a league of their own, located in Vegas, AC, or Uncasville. (A free "Brainwashing" book to the first three people who explain Uncasville!) They demand a new rulebook that recognizes content and strategy--- not trading form.

The ETF derivative market requires a fresh new breed of big picture aware, loophole fillers --- the Obama team is accepting applications.

Whatever happened to stocks and bonds?


Steve Selengut
www.sancoservices.com
The Brainwashing of the American Investor
Professional Investment Management Since 1979

Apr 07 05:49 PM