Can Hedge Fund Replication ETFs Offer Safety?

 |  Includes: HDG, MCRO, QAI
by: Michael Johnston

Over the past several weeks, markets have become increasingly choppy as a number of issues are plaguing the global economy. America teeters on the brink of a recession while debt downgrades and slumping investor confidence have rattled European markets as well. Meanwhile, in emerging markets, inflationary concerns are continuing to wreck havoc leaving investors with few places to put cash to work. In light of this uncertain environment, many market participants have dialed back risk levels, focusing in on sectors that have low levels of correlation to broad markets, such as hedge funds.

While many might think of hedge funds as some sort of ultra-high risk ”black box” type investment, that is not really the case for many products in the space. Instead, hedge funds should be thought of as a way to play broad markets with lower levels of risk. In fact, hedge funds will often take different sides of trades in highly correlated assets seeking to squeak out returns that beat out the market but with much lower levels of volatility.

Unfortunately for many investors, ultra-high minimum investments coupled with an extremely expensive fee structure have kept these products off limits to all but a select few. However, the advent of ETFs that use hedge fund replication techniques have brought these investment styles to the masses at just a fraction of the cost. Of the three ETFs that currently implement Hedge Fund techniques, not a single one charges more than 95 basis points a year; a far cry from the ‘two and twenty’ structure - 2% of assets and 20% of additional profits - that many "traditional" hedge funds charge to their investors.

Yet while these products may crush their more established counterparts on fees, the real question is how they have held up in terms of performance, especially in the strange market that investors have experienced over the last month or so. In light of this, we take a brief look at the three Hedge Fund ETFs below and how they have held up in the recent market turmoil:

IQ Hedge Multi-Strategy Tracker ETF (NYSEARCA:QAI)

This product from IndexIQ seeks to follow the IQ Hedge Multi-Strategy Index which attempts to replicate the risk-adjusted return characteristics of hedge funds using various hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets. Currently, the product is heavy in fixed income securities as LQD takes the top spot at roughly 20% of assets and is then followed by high weightings to EFA (9.1%) and DBV (8.3%).

This focus on short term debt and currency products has allowed the fund to remain relatively uncorrelated with broad markets. In fact, the beta of QAI is -0.17 while the standard deviation is just 0.24%. Over the past three months, this technique has proved to be very beneficial as QAI has outperformed SPY by close to 700 basis points, suggesting it is doing a great job of providing investors a low volatility option in these uncertain times.

IQ Hedge Macro Tracker ETF (NYSEARCA:MCRO)

MCRO follows a similar strategy as QAI but this fund tracks the IQ Hedge Macro Index which seeks to replicate the risk-adjusted return characteristics of a combination of hedge funds pursuing a macro strategy and hedge funds pursuing an emerging markets strategy. Much like QAI, LQD takes the top spot in the holdings at just about one-fifth of total assets. However, the similarities end there for the two IndexIQ funds. The next biggest weights for MCRO are currently the two popular emerging market funds VWO and EEM and then a host of short term bond funds and currency products.

This focus on emerging markets and the pairing of these high risk plays with short term debt and currency funds has given the fund a unique risk/return profile. The beta on MCRO is actually -0.43 while the standard deviation, although much higher than QAI, is still below 0.5%, suggesting low levels of volatility despite its heavy emerging market allocations. From a performance standpoint, MCRO has also outperformed SPY over the past three months although less so than its counterparts on the list. Nevertheless, this IndexIQ product has lost just 3.7% over the past three months compared to a nearly 8.1% slump for SPY, a pretty wide differential.

ProShares Hedge Replication ETF (NYSEARCA:HDG)

HDG Is the newest product on the list having debuted in July of this year. The fund seeks to track the Merrill Lynch Factor Model- Exchange Series, which is a benchmark that seeks to provide the risk and return characteristics of the hedge fund asset class by targeting a high correlation to the HFRI Fund Weighted Composite Index. The HFRI is designed to reflect hedge fund industry performance through an equally weighted composite of over 2,000 constituent funds. Currently, the product has heavy exposure to swaps both in the emerging market and EAFE regions. Additionally, the fund also is heavily exposed to short positions in euro E-mini futures as well, although these positions are collateralized by short-term U.S. debt. In terms of equities, large cap U.S. stocks dominate the list, although several big names from international markets, such as BHP Billiton (NYSE:BHP), Novartis (NYSE:NVS) and Siemens (SI), make up sizable chunks as well. Overall, the fund seeks to be a nice mix between large cap stocks and short-term Treasury bills, although this could change if markets stabilize.

HDG has also exhibited a low beta when compared to broad markets although it seems to be more highly correlated than other products on the list. Standard deviation levels are not yet available due to the fund’s age, but these also look to be inline with the other hedge fund ETFs on the list. Despite this youth, HDG has managed to put up a solid history of outperformance when compared to broad benchmarks. The ProShares fund has lost about 3.1% in the past three months, beating out SPY by nearly 500 basis points in the time frame.

Disclosure: No positions at time of writing.

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