Hedge funds without the '2 and 20?'

Date: Monday, June 22, 2009
Author: John Spence, MarketWatch

BOSTON (MarketWatch) -- Hedge funds have been shaken by poor returns and the Madoff scandal, but that hasn't stopped exchange-traded funds from launching portfolios designed to capture the risk and return characteristics of hedge funds.

These new ETFs don't invest directly in hedge funds. Rather, they use public data on hedge funds to build a portfolio of other ETFs that approximates a basket of hedge-fund strategies.

The funds are marketed as low-cost, transparent vehicles that let individual investors and financial advisers tap into hedge funds without the lockups and "2 and 20" fees. Many hedge funds charge investors 2% of assets, plus performance fees of 20% of profits.

Rye Brook, N.Y.-based investment firm IndexIQ earlier this month launched its second ETF, IQ Hedge Macro Tracker ETF . It followed IQ Hedge Multi-Strategy Tracker ETF , which listed in March. Both funds have an expense ratio of 0.75%, not including the fees and expenses of the underlying ETFs in which they invest.

"The reality is hedge funds are great diversification tools," said Adam Patti, chief executive at IndexIQ, in an interview.

He said the firm's goal is to give investors exposure to hedge funds but without the "impediments" such as high fees, and lack of liquidity and transparency.

How they work

It would be impossible to build a representative index covering the wide gamut of hedge-fund strategies. Before the credit crunch, there were an estimated 10,000 hedge funds controlling nearly $2 trillion in assets.

IndexIQ uses indexes from Credit Suisse/Tremont and HFR as its primary benchmarks. Using hedge-fund return data, IndexIQ uses models to build a basket of ETFs that "replicates" hedge fund strategies in terms of market exposures and trades. The ETFs can invest in commodities, bonds, stocks, currencies and real estate, for example. They can also "short" markets, or bet on price declines. The tracking indexes are rebalanced monthly.

IQ Hedge Multi-Strategy Tracker ETF, as its name suggests, covers six hedge-fund strategies: long/short equity, global macro, market neutral, event-driven, fixed income arbitrage, and emerging markets.

As of June 18, its top two holdings were iShares Barclays 1-3 Year Treasury Bond Fund and iShares MSCI Emerging Markets Index Fund . The ETF also held leveraged, inverse ETFs that are bear bets.

The other fund, IQ Hedge Macro Tracker ETF, is a narrower version that focuses on just two strategies: global macro and emerging markets.

IndexIQ, which also manages mutual funds and separately managed accounts, has about $100 million in assets.

Reception

The ETFs are so new that it's too early to make any judgments about their performance.

According to back-tested data, the IQ Hedge Multi-Strategy Index through the end of May had a 7% five-year annualized return, compared with a loss of nearly 2% for the S&P 500 Index . The hedge-fund index also had lower volatility, which is a key goal of hedge funds -- to deliver good absolute returns with less risk. They aim to hold up in any market conditions, which is why some investors look to hedge funds for diversification, although they don't always deliver on their promise.

IQ Hedge Multi-Strategy Tracker ETF "attempts to provide hedge-fund-like, low-volatility returns with moderate correlation to stocks and bonds," wrote Morningstar analyst Bradley Kay his latest report on the fund.

"Though we are still unsure if it can deliver on its promise, it could be a useful holding for investors willing to take a chance on a new strategy with a solid academic pedigree," he said.

He noted some hedge-fund research has centered on trying to identify the main sources of hedge-fund returns and tracking them. These factors include positions in various asset classes, and credit and currency risks.

Kay pointed out some of the ETF's limitations. First, because it invests in other ETFs, it ends up correlating somewhat closely with traditional asset classes such as U.S. stocks, international equities and bonds. This takes away from its value as a portfolio diversifier.

"This low-risk strategy will underperform during bull markets as riskier assets soar," the analyst wrote.

"Hedge-fund replication by design cannot capture the full benefits of the most talented (or luckiest) managers, even if it matches or betters the diversified hedge-fund composite benchmarks," Kay said