Stay Calm with Hedge Fund ETF

07/11/2012 11:45 am EST

Focus: ETFs

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

It's no time to be swinging for the fences, and this ETF tracks hedge funds with the operative word being "hedge," as in reduce volatility using hedge-fund strategies, observes Ben Shepherd of Investing Daily.

Investors are worried that the global economy could soon be headed for another recession, and those fears have once again inspired a “risk-off” mentality in the markets.

Anxious investors are increasingly looking for ways to insulate their portfolios from market volatility, so they’re turning to exchange traded funds (ETF) that use a mix of alternative investment strategies to achieve that end.

IQ Hedge Multi-Strategy Tracker ETF (QAI) employs a hedge fund-like investment strategy that may not be impressive from a total-return standpoint, but is notable for its ability to limit volatility.

Similar to other ETFs in this niche, IQ Hedge Multi-Strategy Tracker ETF doesn’t try to directly replicate the holdings of hedge funds. Instead, it mirrors the risk-adjusted performance of the broad basket of hedge funds used to create its benchmark index. And those funds use strategies ranging from event-driven arbitrage to long/short equities.

Rather than attempt to produce the alpha-based excess returns resulting from security selection or asset-allocation skills—of individual hedge-fund managers, the ETF tries to capture the beta of the entire asset class.

The exact methodology used by the fund is complex and proprietary, but it essentially reverse engineers the performance of popular hedge-fund management styles to find the mix of assets that most closely matches hedge funds’ risk and returns. It then screens the universe of ETFs to determine which ones can be used to construct a “best fit” portfolio to replicate that risk-adjusted performance.

It’s obviously a complicated strategy, but one which IndexIQ, the fund’s sponsor, has executed on quite well. The ETF was launched just weeks after the bear market bottomed in March 2009, so unfortunately we don’t know how the fund might perform during a period of intense volatility, such as what the market suffered at the height of the Great Recession. However, the fund outperformed the S&P 500 by a wide margin during the sell-offs in the second quarter of 2010 and the third quarter of 2011.

Since inception in March 2009, the fund has generated an annualized return of 3.9%. Although the S&P 500 gained 19.4% annually over that same 3-year period, the ETF produced its return with extraordinarily low volatility, sporting a low beta of just 0.25 versus the S&P 500′s 1.0 and a standard deviation of only 5.2% versus the S&P 500 ‘s 16%.

It also exhibits an extremely low correlation with equities, commodities, and bonds. So while the fund’s total return may not be all that compelling, its risk-reduction properties are quite attractive.

Though I’ve generally been skeptical of this type of investment product, I now believe it could play a key role in dampening the volatility of an investor’s overall portfolio. That makes it a perfect fit for the sleeve of assets you use to hedge your portfolio.

Read more from Investing Daily here...

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