Exchange-traded funds have made investing a whole lot easier for individuals. But what you may not realize is that even super-sophisticated investors like hedge funds use them, too.
Knowing which ETFs hedge funds and other big institutional investors are buying can give you some insight into whether they belong in your portfolio as well.
Finding the answers
With the help of the tracking tool AlphaClone, which looks at the holdings and trading activity of hundreds of hedge funds and institutional investors, I took a look at the most popular ETFs they've been using lately to implement their investing strategies. Here were the top six, in order of popularity.
1. SPDR Gold Trust (NYSE: GLD )
If you don't know why this ETF is at the top of the list, you haven't been paying attention to the investing world over the past year or two. Gold has been in a bull market for 10 years now, and this ETF, whose shares each represent roughly a tenth of an ounce of gold, has become extremely popular. Since its inception in 2004, the fund has grown to monolithic proportions, now holding almost 42 million ounces of gold worth roughly $56 billion at current prices.
Many hedge fund investors, including infamous housing-bubble caller John Paulson, have moved heavily into gold as a hedge against a lack of confidence in the U.S. dollar and other currencies. Although Charlie Munger denounced gold as an investment, many professionals clearly believe that a 10-year trend is worth following for now.
2. iShares Emerging Markets (NYSE: EEM )
Another area that has brought impressive performance to long-term investors is emerging markets. Growth has continued in countries like China and India even as major economies in Europe joined the U.S. with contracting gross domestic product figures. Even as forecasts for developed countries improve, emerging markets are still seen as growing faster still. Growth investors go where the growth is, and emerging market ETFs are an easy way to get exposure.
The iShares ETF is quite expensive compared with some other funds covering emerging markets, however. Cheaper alternatives include Schwab Emerging Markets Equity and Vanguard Emerging Market Stock (NYSE: VWO ) , both of which charge a fraction of the fees.
3. SPDR Trust (NYSE: SPY )
It may be surprising to see big institutions that make money by taking active positions in the market use an index-tracking ETF. But it actually makes sense in many cases, and it reveals a lesson you can use in your own investing.
Sometimes, you won't have any strong ideas of individual stocks to invest in, but you won't want to be in cash, either. An ETF like SPDR Trust is a perfect vehicle for such a wait-and-see approach. When you have a better stock idea, you can then sell your ETF shares to provide the necessary cash.
4. iShares FTSE Xinhua China (NYSE: FXI )
Along the emerging markets theme, China takes center stage. While Brazil and Russia are best known for their huge caches of natural resources, China has a diverse economy that recently took over the world's No. 2 spot from Japan.
One concern about this ETF is that it includes several state-sponsored enterprises that are highly regulated, which raises the potential for government interference that could distort share prices. It also includes a huge allocation to Chinese banks. Although hedge funds prefer the liquidity that ETFs provide, you might do better seeking out individual companies that will benefit the most from changing economic and demographic trends in China.
5. iShares MSCI EAFE (NYSE: EFA )
This broad-based international fund serves two main purposes. First, it's a good placeholder for international stocks in the same way that the SPDR Trust is for U.S. stocks. But equally important, international stocks will benefit if the U.S. dollar continues to weaken against its foreign counterparts.
You'll find some of the world's largest companies among this ETF's holdings. It's not the cheapest international ETF, but as one of the most popular, it's not surprising to see hedge funds using it.
6. Market Vectors Gold Miners (NYSE: GDX )
This ETF is another play on gold, but one with more opportunity for profit. Gold miners often give investors a leveraged play on gold, because for every 1% move in the gold price, a miner's net profits after its costs will move more than 1%.
Blue Ridge Capital's John Griffin has made a major investment in the Market Vectors ETF representing about 5% of the fund's total capital. If the bull market in gold continues, then miners could see even bigger gains.
Do it yourself
Just because top hedge funds are buying ETFs doesn't automatically make them good investments for you. But by understanding the rationale behind hedge fund purchases, you can better assess whether you share the same goals and can therefore use these funds to achieve the same results.