Hedge fund replication ETFs

A natural extension of the ongoing ETF creation boom, we’re starting to see full-blown “hedge fund” ETFs. After examining the funds (strategy, holdings and expenses) I come away unimpressed. I’m referring to IndexIQ’s two “hedge fund” ETFs: QAI and MCRO. They are not expensive, with total expense ratios around 1.0%, but the logic as to what they hold and why is less than obvious, nor do they appear to be in any way positioned to outperform for any smart/unusual/unique/non-consensus reason.

Here’s IndexIQ’s website: http://www.indexiq.com/etfs/etfsiqh.html

Their HF ETFs at the moment:

1) IQ Hedge Multi-Strategy Tracker ETF (Ticker QAI)

2) Q Hedge Macro Tracker ETF (Ticker MCRO)

The “multi-strat” ETF prospectus says that the ETF will try to match the underlying returns of the IQ Hedge Multi-
Strategy Index. They elaborate a bit more:

“The Index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage, and emerging markets.”

So basically what you get is a hodge-podge of various hedge fund strategies, although the allocations and composition of the exact holdings is essentially unknown. I’m not a big fan of low-transparency (not that they’re trying to hide anything, you just don’t really know what they hold and what they’re changing and why). The majority of those pieces can be replicated by just separately buying funds that focus on each specific piece. For example, you can buy the emerging market ETF EEM, any number of “event driven” or “special situations” or “merger arbitrage” funds like the other ones I’ve discussed in previous posts, and you can take your pick of long/short equity funds based on YOUR evaluation of the manager and their track record (QAI doesn’t really have a track record at this point b/c it’s young and simulated returns are dangerous to rely on in the vast majority of situations as the past rarely repeats itself). Furthermore, as of their last holdings disclosure, the fund held 42% of assets in long positions in short-term treasuries (like you need them to earn a treasury yield) and 24% of assets were long the EEM ETF exactly with about 10% of assets in the Powershares G10 currency ETF. So…they’re not doing anything you can’t do for yourself (and if you do it yourself you can control things, which may or may not be what you’re looking for).

The macro fund tracks the performance of the IQ Hedge Macro Index. Looking at their top 10 holdings, the macro fund’s portfolio is slightly-more complicated than the QAI portfolio, but pretty straight forward anyway.  28% of the fund’s holdings are just EEM. There’s a tiny short treasuries position, but it’s dwarfed by the long treasuries positions. The “ultra short” real estate position is one of the few distinguishing positions (tho it’s only 3.7% of fund assets) b/c it’s both short and levered, so presumably they have reasonable conviction that there is further downside in real estate. I don’t see anything here that impresses me or suggests to me that this fund does anything beyond simplify the construction and purchase of a portfolio of emerging market stocks, various treasury and corporate bonds (both US and international), currency ETF holdings, and a small position betting against the real estate sector. All in, MCRO doesn’t do it for me, but I’m not you, and maybe you like the idea of one purchase that requires no follow-up maintenance.

TickerName Weight
EEMiShares MSCI Emerging Markets Index Fund 28.43%
SHYiShares Barclays 1-3 Year Treasury Bond Fund 15.90%
LQDiBoxx $ Investment Grade Corporate Bond Fund 13.29%
BWXSPDR Barclays Capital International Treasury Bond ETF5.63%
BSVVanguard Short-Term Bond ETF 5.23%
SHViShares Barclays Short Treasury Bond Fund 3.97%
SRSProShares UltraShort Real Estate 3.69%
DBVPowerShares DB G10 Currency Harvest Fund 3.35%
TWMProShares UltraShort Russell2000 3.29%
BILSPDR Barclays Capital 1-3 Month T-Bill ETF 1.99%

Strategies For Uncertain Times: Long/Short Equity

L/S Equity or Market Neutral Equity

Overview: Funds are either long/short with some long exposure (not entirely hedged against market movements) or are market neutral (which TRY to be entirely hedged against market movements). This strategy has roughly a 0.60 beta vs. S&P over the last 10 years. Long/short funds either pick their positions based on fundamental analysis or employ quantitative screens for identifying investments. Additionally, not all funds short single stocks against their long positions, and might short various equity indexes or short futures to hedge against market declines. If you’re gonna be long equities at an uncertain time in the macro cycle or at uncertain overall market valuations it makes sense to be long/short as opposed to long-only. Hold in either a taxable or tax advantaged account.

• Open-end mutual funds:
  • HSGFX: Hussman Strategic Growth
    • Long single stocks, short index and buy puts
    • Almost entirely hedged exposure
    • Down 9.6% in 2008, good
    • 1% expense fee
    • No load
    • Low turnover
    • Down 10% in 2008
    • 8% std dev
  • DRCVX: Comstock Capital Value
    • Up to 50% short, solid returns
    • Global
    • UP 50% IN 2008
    • Lose money frequently, negative 5 year annualized return, down 2009 YTD
    • 22% std deviation
    • 5.75% load and 1.7% annual fee
  • COAGX: Caldwell + Orkin Market Opportunity
    • Totally unrestricted hedge fund, great manager, Michael Orkin
    • $25k minimum
  • CVSIX: Calamos Market Neutral A
    • Convert arbitrage and covered call strategies only (roughly 50/50)
    • 1.1% annual expense with 4.75% load
    • 7.7% std dev on 3 year basis
    • 5 year annualized return of 2.2%
    • 110 positions with high turnover
    • MOSTLY covered calls
    • Down 13% in 2008
  • OLA: Old Mutual Claymore Long-Short
    • Long/short equity with covered calls for ~85% of portfolio
    • 130/30, so roughly 20% short with no more than 100% long
    • Specific stock longs and shorts based on quant model
    • Stocks are mostly large cap
    • Beta of 1.07 w/ S&P
    • Down 40% in 2008, very poor performance for a “hedged” strategy
    • 18% std dev
    • 2.7% annual fee
  • BPLEX: Robeco Boston Partners Long/Short
    • No load, 2.75% annual fee
    • Fundamental analysis
    • Down 21% 2008, too much for a “hedged” strategy
    • 13% 5 year annualized return
    • 22% std dev
    • 5 star Morningstar
    • Very diversified, individual stock shorts (20% short)
  • Other poor L/S equity fund choices
    • (HSKSX: Highbridge Statisical Market Neutral: not fundamental, $1m min investment), (ALPHX: Fee too high), (MADEX: Not consistent in returns), (DIAMX: Too volatile), (MLSAX: Closed), (TFSMX: Closed), (AARFX: Too young), (FMLSX: Too volatile), (JAMNX: Weak returns), (TMNVX: The Market Neutral Fund: Just switched advisors), (NARFX: Too new/young, not enough track record)
• CEFs:
  • DHG: Dreman Value:
    • Volatile returns, does have specific stock shorts
    • Has beta of roughly 1.25 w/ S&P (very high)
• ETFs:
  • ALT: iShares Diversified Alternatives ETF. Full range HF multi-strat ETF
    • Objective:Yield/futures arb, technical trades, fundamental relative value
    • Current holdings are mostly currency, IR, and index futures
    • Just started
  • QAI: IQ Hedge Multi-Strategy Tracker ETF
    • Just started

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.