Hedge Fund ETFs: The Door Has Opened

Having been given the option, the vast majority of investors in storied hedge fund Cerberus Capital Management have opted to liquidate their holdings, rather than roll over their investments to a new Cerberus fund. The development is a blow to fund manager Stephen Feinberg, and on a higher level, to the hedge fund industry as a whole. Cerberus, once one of the stars of the hedge fund industry, has seen its reputation tarnished by a series of bad investments, including Chrysler LLC and GMAC LLC.

Beyond bad bets made specifically by Cerberus, the hedge fund industry has suffered in recent years as funds have encountered significant difficulty liquidating their stakes in private investments. As investors have clamored for returns of their capital, many funds were forced to sell holdings into the best buyers’ market in several decades. While hedge funds have proven themselves capable of providing the ultra rich with exceptional returns, many investors are now learning that these investment vehicles may leave them hung out to dry in certain economic environments.

Cerberus is the latest in a long line of hedge funds to be done in by demands for investor withdrawals or plagued by scandals. Ruderman Capital Partners is just one example, as fund manager Bradley Ruderman was recently charged with bilking investors out of about $44 million in a wire fraud scheme.

ETF Hedge Funds

Enter hedge fund ETFs. Pioneered by New York-based IndexIQ, these exchange-traded products were designed to generate returns similar to hedge fund while solving many of the problems that have plagued traditional hedge funds, such as a lack of transparency and liquidity. Because they are organized within the ETF structure, the funds offered by IndexIQ can be bought and sold on the open market, eliminating many of the concerns about liquidity. Also, the holdings of these funds are published on a daily basis, a sharp contrast from sometimes opaque hedge funds.

As the ETF industry continues to grow, so does the complexity of the product offerings. While ETF assets are still held primarily by equity funds tracking well-known benchmarks such as the S&P 500, there are an increasing number of ETFs designed for wealthy investors with high risk tolerances (see our free Guide to ETFs for High Net Worth Individuals for a more thorough description).

With their numerous advantages over traditional hedge funds, hedge fund ETFs seem to be poised for tremendous growth in popularity if investors continue to liquidate assets and look for a new investment alternative.

The Bottom Lines

With traditional hedge funds struggling mightily, hedge fund ETFs have been given a tremendous opportunity to attract gobs of money from wealthy investors fed up with the old school funds. Hedge fund ETFs have performed reasonably well during their brief history, but concerns still remain about their ability to implement true hedge fund strategies. Whether it’s enough to convince recovering hedge fund addicts to give these funds a shot remains to be seen. A quick overview of the performance of existing hedge fund ETFs:

• IQ Hedge Multi-Strategy Tracker ETF (QAI): The first of its kind, QAI is designed to replicate the risk-adjusted returns of hedge funds using various investment styles. At present, QAI’s largest three holdings are SHY (20.5%), EEM (15%), and AGG (12.1%). Through July, the IQ Hedge Multi-Strategy Index had returned 6.2% year-to-date, compared to 7.3% for the HFRX Global Hedge Fund Index and 11.0% for the S&P 500.

• IQ Hedge Macro Tracker ETF (MCRO): MCRO, the second offering from IndexIQ, is designed to replicate risk-adjusted return characteristics of hedge funds using a macro investment style. MCRO also invests primarily in other ETFs, with EEM (24%), SHY (18%), and LQD (15%) comprising the fund’s largest holdings. Through July, MCRO has returned 11.5% on the year, compared to 19.0% for the Credit Suisse/Tremont Global Macro Index.

The hedge fund ETF market is relatively small at present, but it is poised to expand significantly. IndexIQ has filed for approval on more than a dozen funds implementing specific hedge fund styles. In addition, WisdomTree, known for its fundamental weighting approaches to indexing, has filed for three funds that would implement hedge fund strategies, including a real return ETF, a managed futures ETF, and a long-short fund.

As they have pulled assets out of troubled hedge funds, investors have been relatively hesitant to embrace hedge fund ETFs, perhaps due to concerns about their ability to truly replicate hedge fund strategies. It’s too early to tell if these ETFs will have staying power, but the current hedge fund struggles are presenting a unique opportunity for hedge fund ETFs to establish themselves as a viable alternative for risk-hungry investors.

Disclosure: Long AGG.

Comments

[Daniel Moser:]

I must respectfully disagree. Index IQ HF replication is a joke. They are curve fitting historical returns and not actually capturing the "real" source of alpha and probably not even capturing the real beta either. Do you really think that the average Global Macro hedge fund is 33% allocated to fixed income securities? Granted I obviously don't know the answer to that, but somehow I doubt it.

There is definitely an argument to be made that hedge funds fees are too high for the majority of them, but niavely investing into a portfolio of etf's thinking you are going to get a sterotypical hedge fund like returns is preposterous. If you can't actually locate the source of alpha/beta to mimic the returns, there is an inherent tracking risk and even a possible risk of a signficant blow up. Investors should be very cautious with these new ETF's.

Aug 31 02:14 PM

[Adam Patti:]

Mr. Moser,

Happy to discuss the specifics of construction behind the IndexIQ ETFs. Hedge Fund Replication/Alternative Beta is based upon over 10 years of academic research and our particular strategies have approximately 2.5 years of real-money track-record.

QAI and MCRO are designed to deliver the diversification benefits of hedge fund investing without the structural impediments of hedge funds. I think after understanding the products you might feel differently.

Please call me at your convenience at 914-697-4946 or email at [e-mail]. There is also an introductory whitepaper on our website; indexiq.com.

I appreciate your time and consideration.

Kind regards,

Adam Patti
CEO, IndexIQ

Sep 01 04:59 PM

[TiNo the Ar...:]

I may invest $100 in this etf tommarrow..Assuming the Spread, isn't astronomical. Spreads on these thinly traded ETF's can kill you. My broker already charges like .01 cent per share for the first 500 shares in commission. So a big spread would make the idea not a viable one for the working poor like me. i can't wait to tell my friends that i'm a hedge fund investor..

Sep 02 10:25 PM