Sal Bruno, IndexIQ’s chief investment officer, points to research showing that if you decompose the alpha and beta of hedge funds, about two-thirds to three-quarters of the returns are captured by beta. The rest of the returns are captured by alpha characteristics that relate to stock selection.
“We think the typical retail investor and financial advisor can find this fund useful because it gives them a cheap, liquid, transparent and tax-efficient way to get exposure to hedge funds without having actual exposure to hedge funds,” Bruno says.
He adds that QAI won’t mirror big market moves.
“It has a beta of about 0.25 to the S&P 500, so it’s not meant to keep up with strong up moves in the S&P,” Bruno says. “It shines more on the downside, and that’s where hedge funds are meant to do well in terms of capital preservation. ‘The best offense is the best defense’ is the argument for QAI—to protect on the downside.”
QAI’s fund-of-funds index is constructed in a three-step process. The first step looks at six individual hedge fund strategies comprising long/short equity, global macro, market neutral, event driven, fixed-income arbitrage and emerging markets.
“We try to identify the driving factors of performance with each strategy. And we do this once yearly when we revisit the strategies,” Bruno says.
Next, the firm updates the portfolio weights monthly as new hedge fund information becomes available. “For example, are long/short managers having more of a value tilt?”
The third step involves a process that aims to overweight the strategies with the best returns, lowest risk and largest correlation to the broad hedge fund index, and then underweight those with the reverse. “We allocate across the six strategies to try to maximize the Sharpe ratio,” Bruno says, adding that the index is custom-weighted.
The Results
The IQ Hedge Multi-Strategy Tracker ETF began trading 10 years ago, and the AlphaClone Alternative Alpha ETF has been on the market for more than seven years. Given that we’ve been in an equity bull market for the past decade, it’s probably not surprising that alpha-seeking ALFA’s total returns have greatly outperformed those of hedging-oriented QAI. Then again, both have performed the way they’re designed to, so making a comparison based on total returns misses the point.
But regarding performance, ALFA was up more than 33% year to date through November 6. On a longer-term basis, it sported annualized three- and five-year returns of 18.65% and 6.8%, respectively. Maz Jadallah notes the fund’s longer-term record was hampered by the dynamic hedge component of its prior index, which whipsawed the fund on a couple of occasions and caused it to miss out on market rallies. That hurt returns and caused investors to flee. Jadallah says the fund had more than $200 million in assets at its peak, but recently it had about one-tenth of that.
“It’s a recovering ETF story,” Jadallah says. “I swapped out the index to remove the hedge, and performance has been recovering. And people want to see it recover a little more, and then assets will pick up again. And, of course, marketing and distribution is key for the little guys like us.”
He says the ALFA fund is currently on the investment platforms of Envestnet, Raymond James, Stifel, Ameriprise, LPL, Schwab, TD Ameritrade, Fidelity and Interactive Brokers.
The QAI fund returned nearly 7% this year as of early November and had three- and five-year average annual returns of 3.2% and 1.5%, respectively. But investors seem to recognize its role as a portfolio hedge because the fund recently had assets of more than $825 million. It charges a fee of 0.80%.
Bruno says he’s seen advisors peel off some of their 60-40 stock/bond allocation to make an alts sleeve where they take 10% from equities and 10% from fixed income, and go 50-30 and put 20% into alts.
“We think QAI can represent a meaningful portion of that allocation because of its return and risk properties, and the level of correlation to both equities and fixed income typically found in hedge funds, without the problems that come with those vehicles involving liquidity, transparency, etc.,” he says.
Perhaps one strategy for investors looking to capture both the alpha and beta that hedge fund managers and their strategies can potentially offer is pairing these two ETFs in one combination or another within a portfolio’s alts sleeve.