Hedge funds used to be the man. According to a Wall Street Journal analysis of data from hedge fund industry research company HFR Inc., hedge funds employing various equity strategies beat the total returns on the S&P 500 Index by an annual average of more than five percentage points between 1990 and 2009. Since then, such funds on average have trailed the index by almost 9 percentage points annually.

Not surprisingly, wealthy investors and institutional investors who generally pay full freight (i.e., the traditional “2 and 20” fee structure) are jumping ship. According to HFR, hedge funds that rely on stock picking have suffered three consecutive years of net outflows, which is the longest streak of its kind in HFR’s nearly 30 years of data tracking.

But even as investors seem to be souring on traditional hedge funds, or at least on the equity side, they still want a piece of hedge fund-like strategies contained in (much) lower-cost liquid alternative exchange-traded funds. In a recent report, Greenwich Associates forecasts that institutional investments in liquid alternative ETFs will more than double in the next 12 months, to roughly $114 billion. Individual investors and financial advisors also are gravitating toward these funds to a degree in an attempt to diversify their portfolios, using hedge fund-like strategies that run the gamut from long/short and global macro to arbitrage and market neutral.

There are about 40 such ETFs on the market, but this article will focus on two products offering completely different ways to capture hedge funds in a liquid ETF. One is focused solely on generating alpha; the other is all about beta, or creating a hedge against downturns. We’ll start with the alpha-seeking fund.

AlphaClone Alternative Alpha ETF (ALFA)

This ETF tracks the AlphaClone Hedge Fund Masters Index, which invests in the high-conviction stock holdings disclosed by hedge fund managers with high alpha potential. The methodology was developed by Maz Jadallah, founder and CEO of AlphaClone, who says it is akin to “moneyball” for manager selection. Using mandated SEC holdings disclosures (Form 13F), AlphaClone simulates investing in a manager’s holdings and then assigns a Clone Score, or “batting average,” for each manager in their universe. Managers are scored twice a year and the 13F filings from the 10 managers with the highest scores are used to construct the index. The index equal weights the five largest holdings from each of the 10 managers and reconstitutes its holdings quarterly after the latest 13F filings are released.

“When it comes to active managers among hedge funds and mutual funds, the average—meaning an index of these managers—is always poor,” Jadallah says. “But the dispersion, or the difference between the best and worst performers in the index, is very high. So you can still have poor average performance but still have great performers in the index from the outliers. It pays to find the right manager.”

This is a long-only fund, but it wasn’t always that way. It formerly followed an index with a hedge component that could take the strategy from long-only to market neutral, but it ditched that in late December 2017 because, according to Jadallah, advisors weren’t sure where this fit into client portfolios. (As we’ll see below, the market-neutral approach also negatively impacted the fund’s performance.)

He notes the fund’s current iteration makes it a fit in the U.S. large-cap equity bucket.

“Our strategy seeks to be the growth engine inside your portfolio,” Jadallah says. “We don’t seek to replace the S&P 500; we seek to replace other growth-oriented active strategies. So the allocation can depend on how an advisor runs their money.”

The ALFA fund has an expense ratio of 0.69%.

IQ Hedge Multi-Strategy Tracker ETF (QAI)

The QAI fund follows an index seeking to track the returns of distinct hedge fund investment styles. Its goal is to capture the beta portion of returns, which is defined as the returns of hedge funds that are non-idiosyncratic, or unrelated to manager skill. The underlying IQ Hedge Multi-Strategy Index includes both long and short positions in ETFs and exchange-traded products.

As of early November, the fund’s portfolio of nearly 70 holdings was topped by a 17.7% weighting in the iShares Short Treasury Bond ETF (SHV). The list of top 10 holdings also included ETFs investing in Treasury bills, investment-grade bonds, floating-rate bonds, senior loans, international small-cap equities and a currency-hedged international equity fund.

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.