Since the mid-1980s, when a group of traders including Bruce Kovner, Julian Robertson, George Soros, and Paul Tudor Jones rose to fame by delivering previously unimaginable returns, the investing public has been fascinated by the world of hedge funds.
Helping to drive that allure was their exclusivity. For many years, financial regulators allowed only the wealthiest investors to put their money with these managers, and even then funds often closed themselves to new investors to avoid outgrowing their ability to generate outsized profits. While regulations have been loosened now to allow more investors into these funds, there are still significant barriers to hedge fund investing, including high fees, large minimum investments, long lockup periods, and the risk of management fraud.
Seeking to profit from the desire among investors to grab a piece of the hedge fund bonanza, ETF sponsors are now attempting to transfer their success in creating investment vehicles based on index replication to hedge funds. Hedge fund replication is one of the newest, and most exciting corners of the $1 trillion ETF universe. There are now a half dozen ETFs based on hedge fund investing strategies such as merger arbitrage, relative value, or macro/emerging markets marketed by Index IQ and Credit Suisse. They avoid the major hurdles keeping individuals from buying into hedge funds and promise to deliver a substantial portion of hedge fund returns.
These ETFs are not actively managed hedge funds in ETF format, nor do they invest in actual hedge funds. Rather, they offer exposure to hedge funds as an asset class by seeking to replicate the aggregate returns of a group of funds employing a particular strategy. To do this, they use widely available, liquid securities based on common benchmarks like the S&P 500. This can be accomplished in several different ways. One is a "rules-based" approach, in which the ETF builds its portfolio by mimicking the collective set of "rules" a group of hedge funds use to pursue a strategy. Another is a "factor-based" methodology, which uses regression analysis across a range of factors represented by investable securities to recreate an aggregate portfolio. There are ETFs based on both approaches, often built around portfolios of other ETFs.
