Steer Clear of Hedge-Fund ETFs

It was only a matter of time. Exchange-traded funds, which offer products for almost every conceivable investment niche, are now going after hedge funds. You may consider this welcome news if you don’t have the big bucks normally required to invest in hedge funds and don’t want to pay their outrageous fees.

Hedge-fund ETFs don���t follow a simple formula. IndexIQ, the top sponsor of these kinds of ETFs, aims to replicate the returns of hedge funds by investing in other ETFs and futures contracts. Its IQ Hedge Multi-Strategy Tracker (symbol QAI) attempts to replicate six hedge-fund techniques in one fund. Techniques range from selling stocks short to taking advantage of discrepancies in the prices of different kinds of bonds from the same issuer.

The IQ Hedge Macro Tracker (MCRO) tilts more toward emerging-markets stocks and will almost certainly be more volatile than the multi-strategy ETF. The macro ETF endeavors to create returns similar to two types of hedge-fund investing styles -- global macro and emerging markets.

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Global-macro hedge funds search for inefficiencies in the prices of stocks, bonds, commodities and currencies around the globe. Emerging-markets hedge funds try to do the same thing, but exclusively in developing countries.

The biggest ETF purveyor, iShares, has also gotten into the act. Its Diversified Alternatives Trust (ALT) holds futures contracts on commodities, currencies and interest rates, as well as on stock and bond indexes. It seeks to profit from the gaps between the market price and the estimated true value of assorted assets. Unlike most ETFs, Diversified Alternative Trust is actively managed and does not track an index.

Fees on these new ETFs are either fair or high depending on your perspective. The annual fee for the iShares ETF is 0.95%; the IQ ETFs charge 0.75%, although total costs are closer to 1.1% when you include the fees of the underlying ETFs. That’s better than the standard hedge-fund charge of 2% per year plus 20% of the gains, but a lot higher than most ETFs, some of which charge less than 0.1% annually.

Hedge-fund-mimicking ETFs are untested. The oldest fund offered by IndexIQ started in March 2009, and iShares launched its product in November. Many wonder whether these ETFs can come close to reproducing the performance of hedge funds. Michael Johnston, senior analyst of research firm ETF Database, thinks many investors are waiting on the sidelines to see whether funds live up to the hype. “If they impress, the sky's the limit,” he says.

Until we see how these funds perform in different market environments, we suggest you steer clear of them. Instead, consider a seasoned hedge-fund-like mutual fund, such as Hussman Strategic Growth (HSGFX).

Expect more hedge-fund-like ETFs to hit the market. IndexIQ has filed applications with the Securities and Exchange Commission to launch more than a dozen ETFs. “We are creating very specific products for very specific needs investors have,” says Adam Patti, IndexIQ’s chief executive.