If you are new to the realm of stock investing and starting out with modest sums to invest, most likely you have heard of ETFs or Exchange Traded Funds. You have probably learned that ETFs are an easy and accessible way to start investing and gain exposure to stocks and the stock market. You have probably heard about hedge funds and their possible huge returns too. But then you found out that investing in hedge funds is usually reserved for high-wealth individuals. So what if you came across a hedge fund ETFs list? Could this mean that you, as a small investor you could buy regular ETFs through your broker and gain exposure to the lucrative returns of hedge funds? Well, possibly yes.
What is a hedge fund?
It’s probably a good idea if we first define a hedge fund. What is different about a hedge fund than say a fund that just invests in a lot of stocks and bonds? The basic difference is that in addition to taking long positions in stocks, bonds, and other funds, a hedge fund does what the name suggests, it seeks to hedge the downside risk exposures to the fund by taking short positions and positions in financial derivatives.
So is that the only difference between hedge funds and other funds? And if adding derivatives and shorting stocks is such a good idea why don’t other funds do it?
The answer is regulation. To qualify as mutual funds that are suitable for the average investor, the funds have to abide by rules laid down by the Securities and Exchange Commission. Hedge funds are not as tightly regulated and it is recognized that they are higher risk and not suitable for the average investor.
Rather than assume that we all know what a hedge is in investing terms, let’s look at a basic example.
Let’s say you have been steadily building a simple portfolio in a few ETFs. You hold one that tracks the Standard and Poor’s 500 index, this one gives you exposure to large-cap US stocks. Since you didn’t want to be only in large-cap you also have an ETF that tracks mid-cap US stocks and another that tracks small-cap US stocks.
Let’s imagine that it is still early days in your investing journey, your total portfolio is valued at $20,000. Half of that is in the large-cap ETF, and a quarter each is in the mid-cap and the small-cap.
Let’s imagine that the market has been gunning steadily higher for the last few months, dragging all the indexes up pretty much in line with each other. Let’s also imagine that you are tuned into the news and you are watching various sentiment indicators and pundits start to say they are expecting a market correction any time soon.
They expect this correction could happen any time in the next couple of months. You know from the way the market behaves that a correction could mean a drop of anything from 10 to 20 percent and it could take at least 6 months to regain any losses.
Let’s say that your chosen strategy is to just keep buying into your funds irrespective of what happens but you aren’t prepared to see your portfolio drop so much in value. What can you do? You are looking for ways to limit or manage your downside risk and you might be willing to pay a little something for it or forego some of the gains you would get if the market and your funds just keep going on up.
Move into cash
This is something you can do just to feel a bit better. Let’s say you liquidate 10% of each fund in your portfolio, so now you have $18,000 in your ETFs and $2,000 sitting in cash.
Of course, if the market just goes up another 10% your portfolio will gain $1,800 instead of $2,000. But if the market drops by 10% and you are able to get in with your cash at around that 10% mark, and the market recovers 6 months later… those are a lot of ifs. But let’s say that is what happens. If that is the case after 6 months your portfolio would now be $20,222.22 instead of the $20,000 if you had just stayed in the three funds.
So in a sense, moving into cash is a minor hedging strategy, but potentially better combined with other hedging measures.
Buy VIX call options
The VIX is an index that tracks the implied volatility of options on the SPX which is an Exchange-Traded Fund that tracks the Standard and Poor’s 500 index. What does that mean? well, essentially the VIX is a measure of the cost of the options. When investors expect sudden price moves they open more positions in options and that pushes the prices of options and the VIX up.
The VIX tends to increase when the Standard and Poor’s 500 index decreases.
When you buy call options on the VIX you are betting that volatility will increase. This is a tricky strategy to get right though since you have to buy the calls before the market declines and you have to get the strike price right and expiration date far enough out to catch the decline.
Buy indexed-fund put options
This is another effective way to hedge declines in the markets. You buy an out-of-the-money put option with a strike price just below where the index is now and with an expiration date far enough out to catch the market decline.
If everyone is expecting a market decline, these put options are likely to be expensive. If the market goes up your put options will expire worthless so you will have lost the cost of the options you purchased. There are ways to combine options to make this both less costly and to better match what you think will be the more likely extent of price movement.
Let’s runs some numbers on this approach to be clear we understand how it works.
SPY is the symbol of an ETF that tracks by a factor of one-tenth the Standard and Poor’s 500 index. Let’s say the index is at 3,900 so the SPY price is $390.
We think the index could drop 10% so it would reach 3,610 within the next month. Our portfolio would lose 10% from $20,000 to $18,000.
If the index drops 10% then SPY would drop from $390 to $361. Let’s imagine before that drop that we could buy a put option on the SPY at a cost of $1 with a strike price of $382 and 2 months until expiry. Options are nearly always for the buying and selling of 100 shares so even though the option price is quoted at $1 you would pay $100 plus any fees to buy one option.
In this case, our put option would allow us to sell SPY at the price of $382 per share any time before expiration. So once the market price has dropped to $361, our option would gain at least $21 in value, in option terms that is $2,100 as we have to multiply by 100 since the option gives us the right to sell 100 shares at the strike price of $382 which is now $21 above the market price.
We should be able to sell our option on the open market for approximately $2,000 more than we purchased it.
The numbers here are fictitious and just to illustrate a point, but we can see that in this case, we have fully hedged against the risk of a 10% decline in the market at a cost of $100 which is 0.5% of the value of our portfolio.
Other hedging approaches
There are many other ways to hedge a portfolio, including selling covered out-of-the-money call options on stocks you own, selling out-of-the-money put options on stocks you wouldn’t mind owning. Another approach is to move some of your portfolio into assets that are classic safe havens such as gold or long-term treasuries or even stocks in safe sectors such as utilities or insurance.
Hedging is a vast subject in its own right and we were only trying to illustrate a minor point here.
What does this tell us about hedging
If you’ve read this far and much of the above doesn’t make a great deal of sense to you then you can see that hedging can be complex and we have really only scratched the surface of barely a few hedging approaches. And as we said before, hedging using specific strategies is much of what hedge funds do.
Barriers to entry
As we indicated already, with a total portfolio of around $20,000 we would be nowhere near qualifying for investing directly in hedge funds. But we can buy ETFs that buy into hedge funds for us.
What are the hedge fund strategies?
There are some standard strategies that hedge funds adopt. Here are the mainstay hedge fund strategies as categorized by Morningstar.
This is a hedging strategy that has been around a fairly long time. It involves taking long positions on strong stocks and short positions on weak stocks.
It is actually a variant of a tried and tested stock investing strategy called pairs trading. It works like this.
You identify a strong share and a weak share in the same industry and market whose fortunes you have reason to believe will move against each other. In other words, if one does well the other will do badly. An obvious example is company A and company B both launch incompatible products competing for the same market at around the same time.
You are convinced that company A will win and B will lose. You sell short company B and you buy long company A. What’s more, selling short company B will put cash into your account that you can use to buy shares in company A. So this strategy offers inbuilt leverage possibilities.
The competing products example is a rather unusual occurrence. This strategy more typically identifies an under-priced stock and an over-priced stock with a strong inverse relationship to each other in the same sector. The bet is that the market will tend to restore the prices to a more just equilibrium between the two stocks.
One advantage of this strategy is that it tends to even out the market, or systematic risk. It is a bet on the relative performance of company A against company B. If the market turns up or down it should affect both companies A and B in approximately equal measure and because you are long on one and short on the other the market effects will cancel each other out.
The market-neutral strategy is an extension of long and short to the degree that it reduces the exposure to market risk to zero. Most hedge funds that operate on the equity long and short strategy do not go as far as hedging all their long positions. So there is still some market risk associated with the non-hedged portion of the long portfolio.
Following the market-neutral hedging strategy, long positions are completely hedged with short positions. This result is lower risk than the long and short approach but also lower expected returns.
Merger or takeover arbitrage
Here is how this works. Mergers and acquisitions, or takeovers usually involve an exchange of shares. Let’s say company A is trying to acquire company B.
In order for the deal to be attractive to company B’s shareholders, company A has to offer a price that is above the current market price of company B’s shares. Since most mergers involve an exchange of shares, company A will offer to acquire company B shares using a proportion of its own shares. The ratio of company A shares for company B shares puts an implied price on company B shares at a premium with respect to the current market price in order for the proposed deal to be attractive to company B shareholders.
This opens up an arbitrage spread between the market price of company B shares and the offered acquisition price and similarly discounts company A shares with respect to their current market price.
A hedge fund manager will take a long position in company B shares and a short position in company A shares using the same ratio as the proposed deal.
Once the deal goes through, and that means the shareholders and the regulators agree, the hedge fund will pocket the arbitrage spread in prices.
Convertible bonds are corporate bonds that can be converted to shares at a set strike price when the bond expires. In effect, they are a combination of a bond and a call option.
A hedge fund following this strategy will hold a long position on the convertible bond and a short position on the shares that the bond converts to on expiry. The strategy involves balancing the long and short positions to zero in terms of the deltas of the two sides of the position.
To understand this we have to get into how option prices work.
The delta of an option is the rate at which the price of the option varies in relation to small variations in the price of the underlying asset. Delta varies between -1 and +1. This will be easier to see if we take a hypothetical example.
Let’s say we have a convertible bond of company A, that will be worth $1,000 when it expires 12 months from now. Let’s also imagine that this convertible bond can be converted to 100 shares of company A at a strike price of $10. Now let’s imagine that company A stock market price is currently $15 a share.
Let’s also imagine that a call option with a strike price of $10 and 12 months to expiry would cost $7 and has a delta of 0.75. In option parlance that would mean $5 of intrinsic value and $2 of extrinsic value and if the stock price goes up by 1% to $15.15 the price of the call option would go up by 0.75 x $0.15 or $0.1125.
In order to set up this strategy, since we hold the convertible bond which includes the call option, we need to balance this by selling short 75 shares at the current market price of $15. What we are doing is balancing out the deltas on the two positions.
What then happens is that as the market price fluctuates over the next 12 months, if the price goes up you would short sell more shares to balance out the deltas. If the price drops you would reduce your short position.
This is a strategy that thrives on volatility. It works because it obliges you to sell when the price is high and buy when the price is low.
This strategy involves seeking to profit from very small changes in interest rates across different maturities. Essentially it is betting on changes in the yield curve. It is a strategy that works with very small changes and therefore requires a great deal of leverage to achieve reasonable returns.
The event-driven strategy is looking to acquire the debt of distressed companies. The idea is that the company will be subject to some sort of reorganization and the debt, or more particularly the most senior debt will have a high chance of being paid off either very close to par value or at par.
This is actually one of the strategies suggested by Benjamin Graham to enterprising value investors. He advised them to look for special situations. In those days there were rich pickings to be had with the convertible bonds of distressed railroad companies. This article takes a look at Benjamin Graham’s approach to value investing.
There are a whole group of strategies that look for discrepancies of value in different securities from the same issuer or discrepancies in value for debt of the same grades but different issuers These kinds of strategies tend to do well when there are large differences in rates between short-term and long-term debt and between different grades of debt.
Hedge funds that follow these strategies are looking at global macroeconomic trends and seeking to profit from shifting long and short positions in different asset classes such as stocks, bonds, commodities, and currencies.
Quantitative refers to those hedge funds engaged in high-frequency trades driven by algorithms from analyzing large data sets using statistical and mathematical models. The systems they use are usually propriety.
Short-only funds exclusively focus on finding over-valued stocks to bet against them. These funds are the ultimate bears.
There are other strategies that hedge funds can adopt and some strategies are grouped together with hedge fund strategies for convenience. Such would include.
- Managed futures,
- Tactical allocation,
- Hedged downside,
- Sector and factors,
I am including a volatility ETF as a popular way to hedge or profit from market declines.
Compiling a list of hedge fund ETFs
I’ve drawn on a number of sources to compile this list. The strategy listed for each fund is taken from the published fund prospectus. The list is presented in descending order of Assets Under Management, or AUM. As you will see, many of these are tiny micro-caps. If you were considering buying into any of these, you could expect those micro-caps, and that would be anything below about $50 million, would trade on very thin volume, and are likely to be illiquid.
So if you were considering taking a position in one of the smaller ones, you should expect to hold it for a long time rather than moving in and out rapidly.
You will also notice that the strategies don’t always fall into the neat previously defined boxes.
Well, we made it this far on the subject of hedge funds and didn’t once mention Bernie Madoff. Until now that is.
|DBX ETF Trust
|International equities with US dollar hedge
|Tidal ETF Trust
Risk Parity ETF
|IQ Hedge Multi-
Focus 5 ETF
|Targets 5 high performance sectors on equal cap basis
|Invesco S&P 500 Downside
Managed Futures Strategy Fund
CBOE S&P 500 PutWrite Strategy Fund
|Provides a downside hedge for S&P 500
|Large-cap blend, combines multi-assets and growth
|Global X Guru
|Tracks multiple hedge funds
Real Return ETF
|Multi-asset real return using quantitative methods and active fund management
|Cambria Global Momentum ETF
|IQ Real Return
|Multi-asset real return using passive indexing approach
|Quantitative approach to selecting global assets
|Franklin Liberty Systematic Style
Futures Strategy Fund ETF
|Strategy Shares Newfound/
ReSolve Robust Momentum ETF
|Quantitative means to select US, Int'l and emerging market equities with strong momentum
|Global X Russell
|Tracks Russel 2000 through long positions and writing call options
|Tactical allocation between equities and bonds
|ProShares Hedge Replication ETF
|IQ Hedge Market Neutral Tracker
|Equity with downside hedged
|Direxion Dynamic Hedge ETF
|AltShares Merger Arbitrage ETF
|IQ Hedge Event-
Data source1)Yahoo finance
Approximate values for assets under management are given. These are subject to change.
Disclaimer: None of the information presented here should be considered a recommendation to buy any of the investment instruments mentioned in this article. Always consult a professional financial advisor before making investment decisions and ensure that any investments you make are suitable for you.
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Questions and answers
Q. What is a hedge fund ETF?
A. A hedge fund ETF is an ETF that gives the average investor access to the investment strategies used by hedge fund managers. The idea is that individual investors can gain access to the higher risks and rewards experienced by hedge fund investors.
Q. Should I buy a hedge fund ETF?
A. You can add a hedge fund ETF to give your portfolio additional exposure to other risk-return profiles either to reduce the volatility of returns of your portfolio or to increase the expected returns. You should always consult a professional financial advisor before making any investment decisions. You should ensure that any investments you are considering are suitable for you.
Q. Are hedge funds high risk?
A. Hedge funds have different risk and reward profiles than common stock and bond portfolios. Hedge funds can be very risky, and you can incur a total loss.
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