These ETFs Mimic Hedge Funds

NEW YORK (TheStreet) --Some new ETFs are very straightforward. For example, the iShares MSCI Switzerland Capped ETF (EWL) offers plain-vanilla market cap-weighted exposure to that country, and is clearly a suitable proxy for anyone wanting exposure to Switzerland.

Contrast this with funds like the Alpha Clone Alternative Alpha ETF (ALFA) and the Global X Guru Index ETF (GURU). These funds employ different variations of the same strategy: to build a portfolio based on the holdings reported by hedge funds in 13F filings. The idea is that there is plenty of data to support outperforming the S&P 500 by copying hedge fund trades in this manner.

There are a few knocks against mimicking hedge funds this way. For one, 13F data is reported with a 45 day delay. By the time the filings are public, the hedge funds could already be out of the stocks they've disclosed.

There is also derision about the performance of hedge funds in general. Hedge funds were up 7.3% last year according to BusinessWeek, vs. a 29% gain for the S&P 500. Plus, they've lagged the index for the last five years.

Skepticism notwithstanding, ETFs that track hedge funds have delivered as advertised since their respective inceptions. ALFA is up 56% since it began trading in June 2012, compared with 40% for the S&P 500. GURU is up 63% since its debut a week after ALFA, vs. a 37% gain for the S&P 500.

There is one big difference between the two funds that will come into play at some point. ALFA has a defensive component to its strategy; GURU doesn't. If the S&P 500 is below its 200 day moving average on the last day of a month, ALFA will go from 100% long to 50% long and 50% short. This strategy should reduce the fund's drawdown during the next bear market.

GURU has no defensive overlay; it is 100% long all the time. Investors who prefer GURU could employ their own defensive strategy, though. For example, they might sell some or all of the position based on something similar to ALFA, such as the 200 day moving average. However, this might not be tax-efficient if capital gains taxes would be triggered. Capital gains are obviously not an issue in a tax-deferred account like an IRA.

A big benefit of both funds is that they allow investors to bypass the typical 2-and-20 fee structure whereby hedge funds charge a 2% management fee and take 20% of the profit earned. They also allow investors with smaller portfolios to buy in, since hedge funds have a minimum investment of $1 million or more.

Both are reasonably diversified at the sector level. ALFA currently allocates 19% each to technology and consumer discretionary and 15% to health care. GURU has 24% in tech, 19% in discretionary but only 10% in health care. Both funds have modest exposure to energy, telecom and materials and no exposure to utilities.

ALFA and GURU are primarily intended to be used as core holdings along the lines of the SPDR S&P 500 (SPY) or the iShares Core S&P Total US Stock Market ETF (ITOT).

The reality with ALFA and GURU, in spite of industry boilerplate warnings against the practice, the funds buy based on past performance, with the faith that what has worked before will continue to work.

The research supporting the funds sets an expectation of outperformance, and the funds have delivered good returns so far. But there can be no certainty with future results, and it's up to the buyer to decide whether chasing a hedge fund will pay off more than another investing strategy.

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

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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