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How to Mimic Hedge Funds With ETFs

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Allocating part of wealthy clients’ portfolios to hedge funds has been standard practice for years. Although critics challenge the cost-benefit trade-offs of such funds, the industry assets continue to grow, reaching about $3 trillion in 2014, according to Hedge Fund Research.

The qualified-investor requirement shut out most investors. But fund managers’ decisions to offer mutual funds opened their strategies’ potential benefits to the larger universe of investors (and a larger pool of fees, of course). Exchange-traded funds that replicate hedge funds have become another, low-cost access method.

One ETF-based technique is to take the passive approach and invest in a multi-strategy fund that provides exposure to several strategies.

As the number of single-strategy ETFs grows, however, the do-it-yourself option of active allocation is becoming more accessible. That’s the idea behind IndexIQ’s recent launch of two new hedge fund replication ETFs: the IQ Hedge Long/Short Tracker ETF (QLS) and the IQ Hedge Event-Driven Tracker ETF (QED). These funds join IndexIQ’s other specific strategy hedge fund replication ETFs, such as the IQ Hedge Macro Tracker ETF (MCRO), the IQ Hedge Market Neutral Tracker ETF (QMN).

These funds offer the opportunity for investors to track the four major hedge-fund categories:

  • equity hedge (or long/short),
  • event-driven,
  • global macro, and
  • market neutral.

“What we keep hearing [from advisors] is that … ‘I would like to create my own exposure, because my clients may be overweight a certain hedge-fund strategy or a certain asset class now. And I don’t need that represented in my portfolio,’ ” said Adam Patti, founder of IndexIQ in Rye Brook, N.Y. “ Or, ‘I’m looking for more aggressive exposure or a more conservative exposure, or I have beliefs that we’re going into a certain type of economic environment [in which]a specific hedge-fund style will do better than others.’ “

Replication Mechanics 

The ETFs do not invest in the same underlying assets as the hedge funds they’re attempting to replicate. They use style analysis, Patti explains, similar to that used with equity mutual funds.

The process starts with hedge-fund performance data available from sources such as Hedge Fund Research, Prequin or Credit Suisse, for example. IndexIQ analyzes the various hedge fund strategies’ return profiles to determine the core asset classes that are driving their returns. (Details on the indexes’ construction are available on IndexIQ’s website.)

By looking at a return profile of a universe of hedge funds, we could see in our analysis, and this is all rules-based, there’s no active management here, we could determine what asset classes or combinations of asset classes both long and short are driving that return profile,” he explained.

“Once we can determine what that is, the next step is to use liquid proxies for those asset classes. So, in our case, we use ETFs, other firms’ ETFs, the Vanguards, the iShares, the PowerShares and so forth. We use their ETFs as proxies for those asset classes that we’re determining are driving those returns,” said Patti.

The firm reconstitutes its indexes annually to learn if any new asset classes have become statistically relevant to each style’s returns. The review process is largely quantitative, but there is also a qualitative reality check.

“You don’t want to just try to add asset classes or subtract them because it seems to make the return profile of your replication better,” he said. The firm asks, “Does this asset class in fact make sense for fixed-income arbitrage or emerging markets or whatever it may be, to make sure we’re not fitting the data just so it looks good.”

Tracking

Tracking error is a key performance metric for index-based ETFs, and Patti says that the funds’ errors fall within their fees, which are in the 90 to 110 basis points range. That’s significantly less than the fees charged by some liquid-alt mutual funds, which are often 200 basis points and up.

But it’s important for clients to understand that they’re investing in statistically replicated portfolios: They’re not holding the underlying assets held by a specific hedge fund.

If you’re unfamiliar with hedge fund replication, A.J. D’Asaro at Morningstar has written some informative columns on the approach’s pros and cons.

Reading those columns and other commentaries on replication in combination with IndexIQ’s materials will help you determine if and how these funds might benefit clients.

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