Hedge funds were initially developed as an alternative investing method to create absolute returns in terms of alpha. Specifically, alpha measures risk-adjusted return or the return generated by a security, relative to the return you would expect based on its beta. An investment returning more than the return that would be expected based on its volatility is said to generate positive alpha; an investment returning less than its expected return is said to generate negative alpha. In general, hedge funds seek outperformance of a given long-only index benchmark, on a risk-adjusted basis, using limited shorting, derivatives and leverage. With these techniques, hedged portfolios can take advantage of both negative and positive performance expectations for the stocks in their portfolios. Does this strategy actually work when bottled into an ETF?
As for the strategy, many hedge funds have generated significant returns such as David Einhorn of Green Light Capital with a five-year cumulative return of 36.4% through 2011 and John Paulson with a 22% return during this period. With the well publicized success of various hedge funds, ETF providers have decided to get into this game by developing hedge fund like strategies sold as an ETF. All of this is a nice setup for the investor unable to qualify as an accredited investor which means you have to have $1 million in assets or an annual income of $200,000 (or $300,000 if you are married). But do these hedge fund ETFs deliver market beating returns?
Here is a list of hedged ETFs currently being traded on the market and their recent performance:
WisdomTree Managed Futures (WDTI) uses a managed futures strategy that attempts to profit by shorting contracts that have done poorly and going long on contracts that have done well, taking advantage of momentum. WDTI has a return of (-17.6%) compared to the S&P 500 of 7.09% over the past year ending 4/19/2012. WDTI is the worst performing hedged ETF in this study.
iShares Diversified Alternative Trust (ALT) invests in a portfolio of foreign currency forward contracts and exchange-traded futures contracts that may involve commodities, currencies, interest rates and certain eligible stock or bond indices while seeking to reduce the risks and volatility inherent in those investments by taking long and short positions in historically correlated assets. ALT has a return of (-5.05%) over the past year ending 4/19/2012. ALT has a 2012 year to date return of 0.29% compared to the S&P 500's return of 10.82%.
IQ Hedge Multi-Strategy Tracker ETF (QAI) is the first U.S.-listed hedge fund replication Exchange-Traded Fund. QAI is a registered open-end mutual fund that invests in exchange-traded funds (ETFs) and similar securities in an attempt to replicate the performance characteristics of certain hedge fund investing styles, but with less cost, more liquidity, and greater portfolio transparency than traditional hedge funds. The name "IQ Hedge" is misleading as QAI is really just investing in a diversified list of ETFs. QAI has a return of 2.14% over the past year ending 4/19/2012. QAI has a 2012 year to date return of 2.28% compared to the S&P 500's return of 10.82%.
ProShares Credit Suisse 130/30 (CSM) is designed to replicate an investment strategy that establishes either long or short positions in the stocks of certain of the 500 largest U.S. companies based on market capitalization by applying a rules-based ranking and weighting methodology. CSM intends to provide a total long exposure of 130% and total short exposure of 30% at each monthly reconstitution date. CSM has a return of 4.62% over the past year ending 4/19/2012. CSM has a 2012 year to date return of 10.75% which is close to equaling the S&P 500's return of 10.82%.
In conclusion, there is no hard data to support the thesis that hedge fund ETFs can provide superior investing returns based on the ETFs included in this study. The majority of investors will be better to avoid hedge fund ETFs until there is more evidence that these ETFs can deliver over the long term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.