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."

The funds use a variety of strategies to track the hedge fund universe. The IQ funds study the performance of hedge funds. The company assembles a portfolio of ETFs that has the same investment characteristics as the hedge fund universe.

Each month the portfolio is tweaked to keep pace with changes in hedge funds. IQ Hedge Multi-Strategy currently has most of its assets in bonds.

The fund has 21% of assets in iShares iBoxx Investment Grade Corporate Bond ( LQD) and 11% in Vanguard Total Bond Market ( BND). The fund is short euro futures.

IQ Hedge Multi-Strategy tracks a broad universe, following funds in areas such as fixed-income arbitrage and long-short equity. IQ Hedge Macro Tracker only follows macro funds, which can invest around the world, trading currencies one month and emerging market stocks the next.

At the moment the macro fund has big stakes in foreign stocks and currencies. The portfolio has 12% of assets in Vanguard MSCI Emerging Markets ( VWO) and 6% in PowerShares DB G10 Currency Harvest ( DBV).

ProShares Hedge Replication holds individual stocks and derivatives such as futures. The fund currently has a big stake in derivatives that track the Russell 2000 small-cap benchmark. The fund is short the Euro.

Among the most cautious of the replicators is Natixis ASG Global Alternatives ( GAFAX), a mutual fund. While the fund aims to track the broad hedge fund universe, the portfolio departs from the benchmark during periods when market volatility exceeds certain levels. The aim is to limit risk in downturns and protect against big losses.

The strategy passed a difficult test in the turmoil of the fourth quarter of 2008. While the S&P lost 21.9% during the period, Natixis only lost 2.7%. "When volatility soared, we cut our exposure to stocks, and that helped to reduce the losses dramatically," says Jerry Chafkin, CEO of AlphaSimplex, portfolio manager of the Natixis fund.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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