Arthur: A True Hedge Fund In An ETF

January 15, 2014

Hedge funds look expensive and illiquid, unless you look at an ETF like QEH, Main Management's Kim Arthur says.

This is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Kim Arthur, chief executive officer and founding partner of San Francisco-based Main Management.

Hedge funds are a $2.5 trillion asset class, before counting the leverage they employ. They have been around for decades and were originally available only to high net worth individuals.

More recently, their growth has exploded as institutions have increased their allocations. According to Preqin research, larger endowments, foundations and family offices—aka "smart money"—are allocating between 15 and 20 percent into this asset class.

1_Hedge Fund Allocations by Investor Type

A few fundamental issues dog hedge funds, including high costs; tax inefficiency; lack of liquidity; and lack of transparency.

We'll look at those shortcomings, but first, let's look at what we think is a better solution.


2_Historical Performance of HFRI Indices

There is a better solution: the exchange-traded fund, AdvisorShares QAM Equity Hedge ETF (QEH).

QEH is a core hedged equity allocation, as it incorporates multiple hedged equity styles. The universe of managers that QEH tracks consists of roughly 1,000 managers, while all are hedged equity, of varying styles and strategies.

Examples include: market neutral, U.S., non-U.S., U.S. large-cap, U.S. small-cap, Asia, Western Europe, Eastern Europe, Latin America, health care, technology, energy, etc.

Using the core approach with an ETF like QEH minimizes the desire to chase the "hot dot" money manager, and the possibility of buying them near the end of a good run.

To be perfectly honest, I can think of six reasons QEH is a sensible way to achieve core hedge fund exposure. They are:

  1. Long-term risk-adjusted returns of hedge equity are very attractive compared with long-only managers.
  2. Individual manager selection is very difficult (professionally managed fund of funds can't beat the unmanaged indices). See Figure 1.
  3. Downside protection has been consistent. While hedged equity has only beaten the S&P 500 Index 50 percent of the time on a calendar-year basis, hedged equity has experienced half of the calendar year downside, on average, during the last 24 years (-5 percent versus -10 percent) and has bettered the index in 21 out of the 24 years.
  4. Smart beta and dynamic nature of the QEH portfolio. QEH adjusts its exposures as the portfolio managers' analysis sees the equity hedge universe of managers (approximately 1,000 firms in total) adjusting their exposures. The adjusted exposures are:
    1. Overall net exposure (will typically fall between 40 and 70 percent)
    2. Geographic (region and country specific)
    3. Economic sector exposure (current overweights are to financials, information tech and health care; underweights to telecom and consumer staples).
  1. Market cap (large, mid, small)
  2. Value/growth
  3. QEH is a global portfolio. While it varies, QEH typically has up to one-third of its net exposure outside of North America, including not only developed economies but also emerging and frontier markets.
  4. Hedged equity performs well in rising-rate environments. While hedged equity may experience short-term pullbacks, over a multimonth rate move, hedged equity has made money during the six rising-rate periods since 1990 (see "Seeking Alpha: Long/Short Equity in Rising Rate Environments," Sept. 30, 2013 and Figure 3).


HFRI Eq Hdg Ind and S&P 500 Ind Ann Rtns


Another lens through which to view returns of core hedge fund exposure is to examine how those returns vary in different fixed-income environments.

4_15-Yr Moly. Capt. Ratios of Hdg Funds and US Gov Bds

Now that we know why we should have an allocation to QEH, let's go back to those four fundamental issues with hedge funds:

  1. Their high cost
  2. Tax inefficiency
  3. Lack of liquidity
  4. Lack of transparency

Typical hedge funds have annual costs of almost 400 basis points, or $400 per $10,000 invested.

If the manager is consistently good at generating alpha, then this hurdle is manageable. If not, it becomes a very high hurdle.

QEH caps expenses at 150 basis points and aims to match the HFRI Equity Hedge Index, making it a great core solution to your hedged equity allocation. It also allows you to satellite active managers around it.

Most equity-hedged managers are tax inefficient because their marginal investor is a nontax-paying institution.

Furthermore, you get your flash return number at the end of the calendar year, but you don't get your after-tax return until late summer when your K-1 arrives. This makes the job of calculating your after-tax return harder.

With QEH, your taxable event occurs when you choose to sell your position. For 2013, your net return was 12 percent, and your after-tax return was 11.2 percent.

Most equity-hedged managers have lockups and gates that reduce your liquidity.

Since QEH is an exchange-traded product, liquidity is available whenever the markets are open. You are subject to the bid/ask spread and to the premium/discount to net asset value like any ETF.

This is why you need to use limit orders and be aware of the underlying value of the holdings. QEH has more than a year of trading history, but less than $10 million in assets, so you need to be very aware of the above.

Finally, most equity-hedged managers will not share their holdings with you. They feel this is part of their intellectual property, and is the reason they justify their high fees.

With QEH, the underlying holdings are available on a real-time basis. There are no surprises.

As QEH gains popularity, the assets under management should increase and the trading shortfall will abate. In the meantime, this is a great product for one's asset allocation to liquid alternatives as a core holding.

A pioneer in managing all-ETF portfolios, Main Management, LLC is committed to delivering transparent, cost-efficient, and customized investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency.


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