Hedge funds, which use strategies such as shorting and arbitrage to exceed market returns and reduce volatility, have until now been the preserve of the rich. Retail investors who wanted access to these strategies would either have to execute them by themselves or wait until they won the lottery. No more. Over the past three years, several financial institutions have introduced hedge fund ETFs that pretty much anyone can buy through a discount broker.
Canada got its first entrant into this market in April with the Horizons Morningstar Hedge Fund Index ETF. The fund’s managers—unlike most ETFs this one is actively managed—look at the more than 600 hedge funds in the Morningstar Broad Hedge Fund Index and try to replicate, using futures, the most popular strategies the funds employ. It’s an interesting product, and the Hedge Fund ETF has several benefits over traditional hedge funds. For instance, hedge funds typically come with a 2% fee and then take 20% of returns in excess of a certain benchmark. Horizon’s fee, by contrast, is a flat 0.95%. Traditional hedge funds are also illiquid and usually have a minimum holding period. But because ETFs are traded on stock exchanges, investors can buy and sell them as they please.
Howard Atkinson, CEO of Horizon Exchange Traded Funds Inc., says his firm introduced the product because investors who were burned by the equity markets are looking for alternative asset classes that offer a lower correlation to the markets. “They’re trying to get away from that universe, dampen down volatility and eke out some positive return,” he says.
But just because you can easily tap into hedge fund strategies doesn’t mean you should. Rick Ferri, founder of Portfolio Solutions, based in Troy, Mich., and the author of The ETF Book: All You Need to Know about Exchange-Traded Funds, says most retail investors shouldn’t buy this product. First of all, he says, investors aren’t actually buying into a hedge fund. The fund tries to emulate strategies that popular hedge funds use with derivatives. The majority of the hedge fund ETFs look at what the top funds on the hedge fund index are doing and try to copy them. If most are shorting a particular currency, the fund will do that. The Horizons ETF owns a number of different securities—Australian 10-year bond futures, Australian dollar futures, U.S. 10-year note futures, natural gas futures—but no actual hedge funds. These ETFs are so new that there’s no proof that they’ll do what they say they’re supposed to do, Ferri says.
John Gabriel, an ETF strategist at Morningstar, points out that the oldest hedge fund ETF, the IQ Hedge Multi-Strategy Tracker ETF (QAI), has returned 5.5% since 2009, compared to a 44% rise in the S&P 500 over the same time period. Hedge funds are also supposed to have a low correlation to the market, but QAI’s correlation is 75%. Eric Kirzner, a professor of finance at the University of Toronto, says hedge fund correlations should be closer to 10%.
All this suggests that, even in ETF form, hedge funds don’t belong in small portfolios. Ferri thinks there’s only one reason to own a hedge fund ETF: to feel like you’re rich. “People own hedge funds because they can go to cocktail hour and talk about it,” he says. “It’s a status symbol.”