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TheStreet Open House

Hedge-Fund Trackers Shine in Downturns

NEW YORK ( TheStreet) -- Money managers would love to build an index fund that tracks the average hedge fund. Over long periods, hedge fund benchmarks have outpaced the S&P 500. But it has proved impossible to create a hedge fund tracker.

The problem is that to assemble a typical index fund, you must buy many of the issues in an asset class. That's not hard for S&P 500 funds, which hold all the stocks in the benchmark.

For hedge funds, the task is difficult because there are thousands of portfolios in the universe. Many hedge funds are closed to new investors or require minimum initial investments of more than $5 million.

To solve the problem, companies have brought out exchange traded funds that roughly replicate the performance of the hedge fund industry. The choices include IQ Hedge Multi-Strategy Tracker ETF (QAI), IQ Hedge Macro Tracker (MCRO) and ProShares Hedge Replication (HDG).

Unlike star hedge fund managers, the replicators don't seek to deliver outsized returns. Instead, they aim to provide diversification by outperforming stocks in downturns and delivering decent long-term results.

Because the funds have short track records, it is too soon to determine whether the approaches can succeed. But the funds have already demonstrated an ability to outdo stocks during months when markets are falling.

The funds outperformed during the third quarter of 2011, a time when stocks tumbled because of fears about the euro crisis and Washington's debt-ceiling problem. While the S&P 500 lost 13.9% for the period, IQ Hedge Multi-Strategy Tracker lost 2.2%. The strong showing in downturns is not surprising. Hedge funds can sell short, betting that stocks will fall. As a result, the funds have traditionally shined in hard times.

During bull markets, short selling holds back returns. That often causes hedge funds and replicators to trail the S&P 500 in good times. While the S&P 500 gained 12.5% in the first quarter of this year, ProShares Hedge Replication returned 2.1%, and IQ Hedge Macro gained 3.9%. "When the S&P goes up, we tend to lag," says Adam Patti, CEO of IndexIQ, which operates the IQ funds. "When the S&P comes down, we tend to outperform."

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