Hedge Fund ETFs: Replication or the Real Thing?

Includes: ALT, QAI
by: David Ott
One of the key considerations for investors mulling exchange traded funds that attempt to track hedge fund strategies is whether to purchase funds that pursue the strategies directly or through a strategy known as hedge fund replication.
Replication Strategy
Hedge fund replication is a strategy that involves using liquid securities, including futures contracts and ETFs, to replicate the risk/return characteristics of hedge funds.
This strategy was first used by Goldman Sachs (NYSE:GS) for institutional clients who wanted to get immediate exposure to hedge funds as an asset class but needed more time to do due diligence on the specific funds. Goldman used proprietary models to create its Absolute Return Tracker (ART) index and ultimately created a mutual fund to track the index.
The appeal of hedge fund replication products is easy to understand. A typical multi-strategy hedge fund is likely to have layers of high fees, low transparency and complicated tax filings along with holding illiquid investments.
The Index IQ Hedge Multi-Strategy Tracker ETF ((NYSEARCA:QAI)) was designed to avoid all of those negative features and still provide exposure to the risk/return characteristics of a multi-strategy hedge fund with sub-strategies including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets.
Direct Strategy
While QAI pursues the hedge fund replication strategy, there is only one ETF that pursues exposure to multiple hedge fund strategies directly, the iShares Diversified Alternatives trust (NYSEARCA:ALT).
Since I wrote about ALT extensively last month, I thought it would be interesting to compare QAI and ALT since they both pursue alternative beta, but use completely different methods. See my article last month for information about how ALT derives its performance.
Using price returns (as opposed to NAV returns) for the past 18 months from Morningstar, I found that QAI has outperformed ALT. QAI also had higher volatility, but still had a higher Sharpe ratio, a measure of risk-adjusted returns.

This was a particularly strong period for both stocks and bonds, so both alternatives look unappealing ex-post. However, closer inspection reveals an important distinction between the two alternative funds.
If the goal of an investor is low correlation to traditional stock and bond markets, then QAI looks far less appealing than ALT despite the better performance.
Compared to the S&P 500, the correlation for QAI was 0.71 compared to 0.29 for ALT. Compared against the MSCI EAFE, the correlation for QAI was 0.83 compared to 0.24 for ALT. Neither alternative exhibited much correlation with bonds at 0.14 and 0.09 respectively.

Despite the lower performance during the past 18 months, I submit that investors looking for truer diversification in their portfolio look toward ALT instead of QAI given the relatively high correlation between QAI and stocks exhibited thus far. Given that correlation, the higher return (and volatility) isn’t particularly surprising during the current bull market.
Philosophically, I wonder about the merit of investing in a backward looking replication fund like QAI. While the strategy has merit, it is important for me as an investor to understand the source of a return.
I can understand why small caps should outperform large caps or why value should outperform growth. I can even get behind the financial engineering that ALT uses to capture other risk premia like momentum, purchasing power parity or the carry trade.
What I can’t really understand is why hedge funds in the aggregate should produce returns that are attractive on a risk-adjusted basis and lowly correlated with stocks and bonds. It just doesn’t make sense to me that I should weight my investments based on how much money is invested in a strategy. I should invest in each sub-strategy on their merit rather than how much money that strategy has accumulated.
So while I applaud IndexIQ for bringing transparent, liquid and low fee access to hedge fund strategies in QAI, I think investors are likely better served by other solutions like ALT that have similar attributes (daily liquidity, transparency, etc.) but are less correlated with stocks and have an understandable philosophical rationale.
Disclosure: I am long ALT.
Additional disclosure: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members.