Move Over ‘Beta’ ETFs: Make Room for Alpha

There’s a certain element out there in the investment community that believes that ETFs are supposed to be strictly low cost, plain vanilla, equity index funds, i.e. “cheap beta” products.

I suppose I can understand where people got this notion, as for over a decade, the ETF landscape was dominated by just that, “cheap beta” type issues. But nowhere do the rules say that ETFs have to be index driven, or equity driven, or even “low cost.” The ETF structure is simply a package, much like a mutual fund or a UIT (Unit Investment Trust) is a package for a specific investment methodology. ETFs are simply “Exchange Traded Funds”, nowhere does it say that they have to be indexes, equity oriented, nor low cost. There is no “rulebook” on what an ETF should look like and taste like. Just because for awhile there was a lack of innovation in the space, and most ETFs tended to be vanilla, equity driven beta products, does not mean that times will not change.

Nevertheless, there are a great many financial advisors, institutions, and investors who for some reason take the stance “if it’s not passive, it’s not an ETF.” This would be akin to saying “if it’s not actively managed, it’s not a mutual fund” in the 1970s when John Bogle popularized Vanguard’s index mutual funds. How silly would rejection of Bogle’s low cost index mutual funds look today, based on semantics? Because that’s really all it is, simple semantics when it comes to people’s acceptance of many new, innovative ETF strategies. Again, I repeat, the ETF is just the package that allows for added flexibility over stodgy mutual funds, and one should expect the investment strategies that spawn within these ETF packages to continue to evolve.

One company that has challenged conventional wisdom that ETFs should be structured only as beta products is Index IQ. This fund sponsor has rolled out a number of hedge fund replication strategies in ETF wrappers in the past year that are designed to be alpha driven alternatives for institutional as well as retail clients. Traditionally, only institutional clients and high net worth or accredited investors would have access to hedge fund strategies such as merger arbitrage, global macro, long/short equity, and event driven research. Hedge funds generally have very high minimum investment levels as well as screening requirements that have to do with the potential investor’s net worth.

The Index IQ ETFs offer the average investor an opportunity to implement a hedge fund strategy or strategies, into their portfolio. This does not necessarily mean that these ETFs are suitable to every retail investor, as hedge fund strategies tend to be complex and often involve leverage, so if not properly understood by the investor they could be a potential mismatch to that investor’s portfolio objectives.

That said, retail investors should defer to their financial advisors to see if Index IQ’s products fit their portfolio needs, and institutional investors who retain a consultant should ask them what their thoughts are.

Whether or not the products are a fit for any given investor is not the real point of concern, but for the ETF industry, the fact that a robust variety of strategies, both beta driven and alpha driven are at least available currently, and for potential investment consideration for use in one’s portfolio, is quite exciting.

(QAI) (Index IQ Hedge Multi-Strategy Tracker) was launched in March of 2009 and essentially is an ETF of ETFs, where the objective of the fund is to have low correlation to traditional asset classes as well as low volatility to the equity markets (much like the objectives of market neutral type hedge funds themselves).

Unlike hedge funds, (QAI) offers diversification as well as full transparency of the holdings (published daily). Remember that with ETFs an investor can check the fund holdings regularly, and with a hedge fund, the best an investor will do is to see quarterly filings that have a 45 day grace period from the end of a quarter to post to data sources such as Bloomberg. Talk about dated information.

Unlike an individual hedge fund which generally charges 2% per year plus 20% of the annual profits to the investor, QAI is priced at 75 basis points per year. The investment methodology screens through the full universe of ETFs and runs a number of mathematical screens to decide which asset classes are appropriate with the given strategies that the fund will implement. ETFs can be bought or sold short within (QAI), and the top 10 current holdings include (LQD), (EEM), (SHY), (DBV), (VWO), (BSV), (HYG), (JNK), and (SHV).

The fund has short exposure through Russell 2000 futures. Long/short equity, equity market neutral, global macro, fixed income arbitrage, event-driven, and emerging markets are all hedge fund strategies that are fair game within (QAI). That said, a combination of these strategies allows the investor to participate in market upside and mitigate downside risk at the same time, unlike just being 100% long equities, as you would be in say (SPY), (IWM), or (VWO).

Furthermore, hedge funds themselves are sometimes subject to the manager’s staying power, much like mutual funds. A manager can shoot out the lights one year, and strike out royally the next. You don’t run this “emotional”, “manager specific” risk with Index IQ’s replication strategies because the methodologies are rules based and mechanical as opposed to being dictated by a wily manager.

With a little bit over a year of live performance under it’s belt, (QAI) has returned 9.56% in the trailing 52 week period, which has actually underperformed the HFRX Global Hedge Fund Index, which returned 12.27%. However, making judgments on the basis of 1 year performance is never a good recipe for long term investment success.

(MCRO) (Index IQ Hedge Macro Tracker) is also an ETF of ETFs, and has a 75 basis point expense ratio and from an investment standpoint, pursues a macro strategy as well as an emerging markets strategy. So it effectively blends two well known hedge fund strategies that institutions favor as far as investment merit. MCRO launched in June of 2009, so it doesn’t quite have a year of performance behind it, but is up 7.45% since inception versus the HFRX Global Hedge Fund Index up 7.72%. Top current holdings of (MCRO) include (EEM), (SHY), (LQD), (VWO), (BSV), (DBV), (BWX), (DBC), and (SHV), and the fund has short exposure through Russell 2000 futures.

(MNA) (Index IQ ARB Merger Arbitrage) has a 75 basis point expense ratio and replicates a popular and well followed hedge fund objective, merger arbitrage. This is where portfolio managers invest in companies where there has been a public announcement of a takeover, and the manager purchases the takeover target equities and hedges against a general equity market decline with broad based index futures. As of the end of 2009, top holdings in MNA were Sun Microsystems (JAVA), BJ Services (BJS), Affiliated Computer Services (ACS), Cadbury PLC (CBY), and other single equities. Unlike (MCRO) and (QAI), (MNA) is not an ETF of ETFs. For short exposure MNA has used S&P 500 futures as well as MSCI EAFE futures. MNA has not been around terribly long, launching right before Thanksgiving of 2009, and it’s return since is 3.37%.

One “objection” that will surely come up when looking at the Index IQ product line is “lack of trading volume.” This is a stumbling block for dozens of upstart ETFs, as the misconception that trading volume determines liquidity has been oft repeated in the press to the detriment of investors and ETF issuers. I outlined the holdings of the three Index IQ products above, and you can see that in the cases of (QAI) and (MCRO), the holdings are extremely liquid and heavily traded ETFs. And for MNA, the holdings are heavily traded, and primarily large cap equities. It is true that the Index IQ products may not have significant trading volume each and every day and visual bid/ask spreads and “displayed” liquidity may be light (the number of shares that shows on electronic screens on the bid/ask), but this does not, I repeat, does not mean that large orders cannot be facilitated in an orderly fashion in these ETFs.

If you have any doubts about this, contact me, as we deal with inquiries of this nature on a daily basis, and I assure you that you will be pleasantly surprised by your results.

Are hedge funds for everyone? Absolutely not. Are hedge fund replication ETFs for everyone? Also, a no. However, the fact that the strategies are available in a relatively low cost, ETF package, that is highly transparent and methodical, bodes well for those who are becoming more knowledgeable about alternative asset classes and how they can complement a traditional investor’s portfolio. As ETF investors become more educated and sophisticated, which is a sure bet, strategies such as those offered by Index IQ will be embraced more readily and the days of thought of ETFs being strictly equity driven low cost beta products will seem like a distant past.

Perhaps the Index IQ folks will be able to look back in 20 years and grin at how “different” eventually is embraced, just like John Bogle of Vanguard has been doing for the past 20 plus years.

Written By Scott Freeze From Street One Financial (S1F)

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