Hedge Fund ETFs: Hedge Funds for the Rest of Us?

The ivory tower academicians can espouse the efficient market theory until the cows come home, but here in the real world, there's no question that you can beat the market -- at least if you're invested in an average hedge fund. According to Greenwich Alternative Investments, which has been tracking hedge fund performance since 1988, the average hedge fund has a compounded annual growth rate of 13% over the past 23 years, as compared to 7% for the S&P 500.

Sounds good, but alas, government regulations restrict hedge fund managers to accepting only so-called "accredited investors" -- which means you have to have $1 million in assets or an annual income of $200,000 (or $300,000 if you are married). That leaves a lot of us out -- and even more of us after a new Dodd-Frank provision goes into effect, prohibiting you from counting the value of your house in your assets tally.

In the last couple of years, however, the same folks who brought us the exchange-traded fund revolution have attempted to cash in on hedge fund mania by offering ETFs that aim to generate hedge-fund-like returns -- or, at least, to follow one or more of the strategies that have generated such returns.

Where are the returns?
So far, the reception for these "hedge funds for the rest of us" has been decidedly underwhelming. The ETFdb folks currently list 11 ETFs in their "Hedge Fund" category. None of them has anywhere near $1 billion in assets or average daily volume of one million shares traded. (Generally, I don't recommend investing in any ETF that does not meet those criteria because of liquidity concerns.) It appears that investors have pretty much dismissed this entire effort out of hand. But let's take a closer look to see if there are any diamonds in the rough among them.

Here is a compendium of how these funds performed from their respective inceptions through the end of 2011:

Source: ETFdb. Cost = Opening price for ETF on the day of inception. Price = Closing price for ETF on Dec. 30, 2011, plus any dividends since inception. ROI = Return on investment (negative if ETF per-share valuation has declined since inception). CAGR = Compounded annual growth rate, the annualized ROI for this position since inception.

One immediate question is: How are investors evaluating these ETFs? (The few that are paying any attention, that is.)

Interestingly, the two most popular funds don't come close to topping the performance charts. WisdomTree Managed Futures Strategy Fund (NYSE: WDTI), with the most assets under management at about $250 million, comes in second from the bottom in terms of performance since inception. Similarly, IQ Hedge Multi-Strategy Tracker (NYSE: QAI), with almost $200 million, also finishes below average. Meanwhile, Credit Suisse Merger Arbitrage Liquid Index (NYSE: CSMA) posts top performance but has barely $90 million under management.

It's disappointing not to see any of these funds with returns at the 13% long-term rate of hedge funds. But of course, the true test is how well they perform relative to the market overall.

Here, though, there's a problem: The oldest of these funds dates from mid-2009, and that's not nearly enough time to reasonably assess long-term performance. But for what it's worth, here are the (preliminary) data:

Source: ETFdb. SPY CAGR = Annualized ROI of the SPDR S&P 500 ETF since inception of the pertinent hedge-fund ETF. PR = Performance rating.

I define "performance rating" as the difference between the CAGRs of the SPDR S&P 500 ETF and each hedge-fund ETF since its inception. So even though the IQ Hedge ETF lost money for investors, the S&P lost more -- giving the ETF the strongest relative performance and showing that all those investors who made it the second-most popular hedge fund ETF maybe weren't so dumb, after all.

Some preliminary conclusions
Bottom line: It's still way too soon to draw any hard conclusions. But it is a bit disappointing that, far from doubling the performance of the S&P 500, nine out of 11 hedge-fund ETFs are trailing it. And when the S&P 500 is simmering along at 3.2%, while the average performance of the hedge fund ETFs is a chilly -1.9%, it is less than awe-inspiring.

If you are not an accredited investor, based on these early returns, you should probably not be counting too much on the ETF hedge funds to help you get there.