Should investors be using hedge-fund ETFs?

Imitating hedge-fund strategies at a fraction of their fees, these funds could provide valuable protection

Should investors be using hedge-fund ETFs?
Look south of the border, and you’ll see US investors feeling good yet uneasy from a long-running bull run in the equity markets. Fearing that the party may soon end, some may want to invest in strategies that include more downside protection, such as hedge funds. Others, however, may want to get that safety net for less.

The typical hedge fund charges annual fees topping 1.5% of customers’ assets plus up to 20% of profits — though they’re getting pressured to lower those prices. Meanwhile, annual fees for hedge-fund ETFs in the US would generally fall between 0.5% and 1%, reported Fortune.

Citing FactSet data, Fortune said there are 36 hedge-fund ETFs in the US. The oldest one, the IQ Hedge Multi-Strategy Tracker (QAI), also happens to be the largest with US$1.1 billion in assets. The portfolio is essentially a cocktail of strategies, covering both long and short positions across asset classes that include US stocks and bonds, as well as those from emerging markets.

“A look inside QAI’s portfolio, however, is instructive: It gets much of its downside protection from products investors could buy themselves, at notably lower prices,” Fortune said. It reportedly had 52% of its assets in short-term Treasurys or US corporate bonds, and its largest holding is the Vanguard Short-Term Bond ETF, which has an expense ratio of 0.07%.

The fund-of-fund structure is not unusual among hedge-fund ETFs, and sellers reportedly justify their higher fees by pointing to the value of assets that hold their value during stock-market failures. Still, like many other ETFs, most of these products haven’t been tested in recessionary conditions.

The report cited a Vanguard study comparing how far different fund indexes slid from November 2007 to February 2009. A “fund-of-fund” index tracking hedge-fund performance reportedly shed 18%, while an unhedged portfolio of 60% stocks and 40% bonds declined by 25%; the S&P 500 dropped by more than 40%.

“But since then, hedge funds as a group have consistently lagged the broader market,” Fortune said. “Hedge ETFs have followed a similar arc.”

Mariana Bush, the head of ETF research at Wells Fargo Advisors, was quoted as saying that it would probably make more sense to invest in the assets that underlie hedge-fund ETFs. As for investors who insist on using them, she recommended investing in ETFs with at least US$100 million in assets.

And hedge ETFs, like hedge funds, do best in down markets. So when equity markets are up like they are right now, it’s a good idea to use them sparingly.

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