From the February 2011 issue of Investment Advisor • Subscribe!

Replication Offers ETF Investors Hedge Fund Exposure

Since the mid-1980s, when a group of traders including Bruce Kovner, Julian Robertson, George Soros, and Paul Tudor Jones rose to fame by delivering previously unimaginable returns, the investing public has been fascinated by the world of hedge funds.

Helping to drive that allure was their exclusivity. For many years, financial regulators allowed only the wealthiest investors to put their money with these managers, and even then funds often closed themselves to new investors to avoid outgrowing their ability to generate outsized profits. While regulations have been loosened now to allow more investors into these funds, there are still significant barriers to hedge fund investing, including high fees, large minimum investments, long lockup periods, and the risk of management fraud.

Seeking to profit from the desire among investors to grab a piece of the hedge fund bonanza, ETF sponsors are now attempting to transfer their success in creating investment vehicles based on index replication to hedge funds. Hedge fund replication is one of the newest, and most exciting corners of the $1 trillion ETF universe. There are now a half dozen ETFs based on hedge fund investing strategies such as merger arbitrage, relative value, or macro/emerging markets marketed by Index IQ and Credit Suisse. They avoid the major hurdles keeping individuals from buying into hedge funds and promise to deliver a substantial portion of hedge fund returns.

These ETFs are not actively managed hedge funds in ETF format, nor do they invest in actual hedge funds. Rather, they offer exposure to hedge funds as an asset class by seeking to replicate the aggregate returns of a group of funds employing a particular strategy. To do this, they use widely available, liquid securities based on common benchmarks like the S&P 500. This can be accomplished in several different ways. One is a “rules-based” approach, in which the ETF builds its portfolio by mimicking the collective set of “rules” a group of hedge funds use to pursue a strategy. Another is a “factor-based” methodology, which uses regression analysis across a range of factors represented by investable securities to recreate an aggregate portfolio. There are ETFs based on both approaches, often built around portfolios of other ETFs.

The oldest and largest of the hedge fund replication ETFs is Index IQ’s IQ Multi-Strategy Tracker ETF, which started trading in March 2009. This fund seeks to replicate “the risk-adjusted return characteristics of the overall hedge fund universe.” It tracks a composite index that is based on sub-indices for six different hedge fund strategies: emerging markets, long/short equity, global macro, market-neutral, event-driven, and fixed income arbitrage.

To create each sub-index, Index IQ calculates the correlation of return of each ETF meeting certain eligibility criteria relative to independently reported hedge fund returns. It then determines which hedge fund style the investment strategy of each ETF corresponds to and assigns a score based on the degree of overlap. The return correlation and the overlap score are then added to create a ranking; back-testing and other processes determine a final weighting. For the Multi-Strategy fund another algorithm is used to determine the weighting that would produce the closest correlation with the independently reported returns, as well as maximize its own returns and minimize volatility. As of year-end 2010, its top three holdings were the iShares Barclays Aggregate Bond Fund, the iShares MSCI Emerging Market Index, and the Vanguard Total Bond Market ETF.     

S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_Scully@standardandpoors.com. Send him your ideas for ETF story topics.

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