ETFs Take on the Hedge Fund Industry

The year 2008 was rough for the once-lofty reputation of hedge funds, but this topic still attracted a lot of attention from the Inside ETFs conference attendees. With good cause, too, as these panelists knew that hedge funds should seek to provide diversification and downside protection rather than leveraged exposure to market risks. After a quick introduction, three panelists dove into the reasoning and methods behind their own alternative-asset and multistrategy ETF portfolios.

Adam Patti of IndexIQ began the discussion by declaring that the various categories of hedge funds produce far less alpha than they produce of "alternative beta." What he meant by this term was that, with the explosion of hedge funds through the 2000s, many funds now carry out extremely similar investment strategies and enter into the same trades. When these profitable trades and value dislocations become so well-known that nearly every fund in a category enters them, it can no longer be considered a skillful investment worth the hedge funds' exorbitant fees. IndexIQ believes that it can tease these common trades out of the returns for major categories of hedge funds using a technique called performance attribution, then replicate the trades at a low cost using ETFs. The company has already started a mutual fund of ETFs based on its hedge-fund-replication indexes, and it hopes to issue ETFs of ETFs in the coming year.

Morningstar's Take: Although we agree that hedge funds mostly pursue common strategies not worth their high costs, we are cautious about providers pushing their own products. Their indexes' value lies in the "secret sauce" of their performance-attribution models, and there was very little insight given into how to replicate hedge fund returns for oneself. Regarding the indexes, we find the concept behind hedge-fund replication with low-cost ETFs intriguing but remain quite skeptical about the execution until we get a chance to dig in further. A full explanation of our excitement and skepticism would take several articles (and we hope it will), but for now we will just say that the efficacy of their strategy hinges upon a relatively untested attribution model and that many common hedge fund strategies require unusual risk exposures that don't yet exist in the ETF structure.

Chance Carson of Alpine Strategies then spoke up about the potential for returns in lesser-known asset classes with little correlation against the broad market. These formerly exotic asset classes, such as commodities, currencies, and real estate, are now readily available to individual investors via major ETFs. Although these areas of the market still suffered heavy losses in 2008, they provide substantial diversification benefits in most environments and are some of the best inflation hedges. Carson also spoke excitedly about the new strategy-based ETFs entering the market, which exploit long-standing returns patterns to generate profits on both long and short trades. He singled out the managed futures space, which was once the exclusive domain of hedge funds and expensive Commodity Trading Advisors, but has now been captured by a Standard & Poor's index called the Diversified Trends Indicator. This index takes long or short positions in a number of currency, bond, and commodity futures based on each contract's multimonth momentum and captures the tendency for returns on these futures contracts to persist over time. Rydex has already issued a mutual fund based on this index, but no ETF tracks it yet. Carson mentioned  ELEMENTS S&P CTI ETN  as an intriguing new fund based solely on the commodities side of the Diversified Trends Indicator Index. He finished up by stating that he himself had taken a bullish position in precious metals because of concerns about current monetary policy and potential future inflation.

Morningstar's Take: This sounds awfully familiar to us. We broadly support the innovation that ETF providers have given to the market and the new strategies and exotic exposures that they have opened to individual investors for the first time. We prefer to refer to these new indexed investments, with their transparent and easily comprehensible methodologies, as the sought-after "alternative beta." These products may sometimes invite hot money, but it is our job to educate investors on how these unfamiliar funds behave and where they can prove to be useful. For disciplined asset-allocation investors with long-term goals, these new asset classes and risk exposures could ultimately provide more benefit than any of the superspecialized equity ETFs that have proliferated in recent years. The ELEMENTS S&P CTI ETN has already found a place in our hands-off model portfolio, and we remain open to promising new diversifier ETFs and ETNs as they become available.

The third panelist of the day was Jeffrey Huge from Smith Barney, who spoke about his group's own attempts to implement hedge-fund-style strategies using ETFs. While IndexIQ seeks to quantitatively discover and replicate the strategies of existing hedge funds, Huge bases his positions purely on his group's own research, using a variety of momentum, valuation, and technical indicators to create buy and sell signals. He expanded a bit on their process, saying that they comb through the universe of larger and more liquid ETFs, looking in particular for funds that have a low downside capture relative to the S&P 500 (that is, when the S&P 500 has declined in the past, these ETFs on average declined very little). From that list, his team then puts together a number of trade ideas based on its opinions of the market valuations and movements. It recently had considerable success in its Treasury bond investments, as Huge claimed to have seen the potential for deflation coming in 2007. As that bet on long-term Treasuries paid off handsomely in late 2008, the team noticed unusually low inflation prediction embedded in TIPS prices versus Treasuries and made another rewarding bet by going long in TIPS while shorting long-dated U.S. bonds. In the wrap-up, Jeffrey stated that he also felt bullish about precious metals, suggesting that his team also fears the potential for inflation stemming from the Fed's recent moves to boost liquidity.

Morningstar's Take: Although interesting, Huge's presentation did not actually help anyone invest in ETFs unless they, too, have the Smith Barney macroeconomic research team at their disposal. However, it did illustrate the ease that ETFs bring to macroeconomic trend investing and their usefulness to institutions as well as individuals. As for the trades themselves, we were particularly interested to hear about the Smith Barney team's successful bet that long-dated Treasuries were a bit bubbly while TIPS looked cheap. Here at Morningstar, with our Hands-On portfolio, we can pull on our economic and equity analysts' research to look for similar mispricings in the capital markets, and the profusion of sector, country, style, and fixed-income ETFs available today make it easier than ever to act on these investment theses. However, this sort of investing requires considerable expertise with the underlying economics and lends itself to frequent trading that can eat away a portfolio's value in no time.

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