Investment Risks in ETFs That Are Hedge Funds in a Box

Jun.29.10 | About: iShares Diversified (ALT)

A lead article recently in Bloomberg ETFs Gone Wild brings up a valid question: are newer investments called hedge-funds-in-a-box suitable for an an individual investor that does not understand the details of what is happening inside this box?

In this article, I analyze the quantitative characteristics (expected return and risk) of such a hedge-funds-in-a-box to demystify it for the simple investor.

To dig into a hedge fund in a box, I use the real life example (mentioned in the referenced article) of the Diversified Alternatives from iShares, with the ticker symbol ALT. An 'absolute return fund' such as ALT, the Diversified Alternatives from iShares, is effectively an alternative to holding a cash investment. If cash is yielding virtually 0% in June, 2010, and ALT is able to deliver 3-4% with low volatility over a one-year holding period, it would have succeeded in its mission of being a good alternative to a CD. If, on the other hand, there are unforseen risks that make it deliver a negative return in the same time period, perhaps the investor should just buy a CD with an APR of even 1% and forget about all the moving parts in this box.

For the expected return side of the coin, the article states this ETF blends three strategies that many hedge funds use to insulate their performance from wild swings in the markets. The “momentum/reversal” approach tries to anticipate which way a group of equity indexes, interest rates and commodities are going to move by looking at price history. If a stock index’s recent surge exceeds past performance, the ETF goes long; a slide below historical levels cues a short position. The other two approaches hunt for baskets of securities that are under- or overpriced and exploit changing spreads between groups of fixed- income securities and commodities contracts.

As a quantitative investor (see here), I can tell that iShares evidently included these 3 strategies in this box because each of them were separately found to be statistically effective over some historical back-testing period and also because there was lack of correlation between the moves in those 3 strategies.

Looking at the other risk side of the same coin, I find that one investment risk is that if the future turns out be different than conditions present in the back-testing period, the expected returns are unlikely to materialize. This may happen due to

1. contagion effect: in times of crises, the correlations between the three strategies may change to be diametrically opposite from the normal, leading to the fund dramatically under-performing, i.e. not behaving as a low-risk, cash like investment

2. the expected excess return from each of the three constituent strategies may not be achieved as other market participants figure out those alpha sources and start adopting them. As an example, over the 1990s, a standardized unexpected earnings (SUE) indicator that used to give large excess returns became less effective over a decade long period, as most market participants started incorporating it automatically using computers.

Additionally, the following bigger risks exist in such an ETF investment:

1. Very low trading volume, of a few thousand shares a day, leading to large transaction costs, akin to suffering a large bid/ask spread when investing in some options.

2. Basis risk is the price discrepancy between the real cash value and reported NAV of this ETF. Since a large number of this ETF's constituent financial instruments (e.g interest rate swaps or currency forwards) must be traded over-the-counter (OTC) and not exchange-traded, their prices are received a day late, and may be themselves dependent on other OTC instruments prices. So, in extreme situations such as the Black Monday market crash of October, 1987 or days in August 2007, NAV price values that this fund will show may be completely out of whack from reality. Folks that try to sell in such times of distress could be forced to take a 10% haircut or more, for a fund that is supposed to be as good as cash.

Vanguard's Bogle's fears of such hedge funds in a box causing catastrophic freeze-ups could well be realized once such ETFs become a sizable part of the daily trading volume in the markets. Basis risk described above could then become large and the price discrepancy between the real cash value and reported NAV could become large and grow larger as time goes by in a 'flash crash' as was caused in May 2010 by high-frequency trading. The good news is that if such an ETF investor does not panic and try to withdraw their money in times of such panic, in a few days, the market would settle down, and the 'cash substitute' nature of the ETF would reassert itself by the NAV to cash discrepancy vanishing.

Disclosure: No positions held