HANOVER, NH (ETFguide.com) - Some firms have been offering "hedge fund" like ETFs, for example, the IQ Hedge Multi-Strategy Tracker ETF (NYSEarca: QAI). Such schemes construct their portfolio with one-part speculative ETF, like the iShares MSCI Emerging Markets Index (NYSEArca: EEM) and one part "hedging" fixed income ETFs. Is paying someone 75 basis points to put most of your money in bonds really hedging? No. True hedging is where you take an opposite position to your long position.
If you own high-end retailer Nordsrom, your best hedging play wouldn't be fixed income, it would be Walmart. The media constantly misuses the term "hedge fund" when they really mean limited (investment) partnership. True hedge funds are very specific about what they hedge and they are only invested in by institutions with positions in which the hedge fund is a good fit.
In short, genuine hedge funds are not bought as stand-alone products. They service specific needs. If you don't understand your need you shouldn't be in them.
For those who want to hedge, but see the shortcomings of the pre-packaged hedge funds, I've created some hedging recipies to get your started.
Here's my recipe for Max's ETF triangles.
Most hedge funds are created using pairs of securities. The first is expected to rise and the second to fall. The second security diversifies out market risk from the first. If all goes well, the first will go up higher than the second falls, delivering a positive, better risk-adjusted return.
The first ingredients we need are pairs of uncorrelated ETFs. I created these programmatically.
Then I wondered if I could reduce the risk of both ETFs. I then had the ah-ha moment of seeing a triangle of ETFs where an ETF pair is anchored by another ETF that is equidistically un-correlated (as much as possible) from the original ETF pair.
Here is a graphical representation:
The ETF Triangles are created as follows. We take a group of ETFs and calculate the correlation (r-squared) of every ETF to every other ETF (ETF pairs). We then match up two ETFs with low correlation. In other words, we expect that they won't behave the same in the future. We then find a third ETF that has the lowest correlation to the first two. Although any ETF may have high volatility, the group will have low volatility.
Once an investor has an ETF Triangle they can allocate slightly more money to the ETF expected to rise, knowing that the other two ETFs should keep its volatility down. Keep in mind that one will lose return in exchange for reduced risk.
The following chart shows an ETF triangle for EEM. The EEM Triangle is one of thousands of ETF Triangles I created. The black line shows the return of a pseudo hedge fund portfolio of these three ETFs. You don't need to be a mathematician to see the lowered volatility.
Here is the return and volatility for this DIY Hedge fund using three ETFs.
The iShares Nasdaq Biotechnology (NYSEArca: IBB) has a low correlation to EEM. SPDR Gold Shares (NYSEArca:GLD) has an r-squared of .06 to EEM and .00043 to GLD.
To view more about this new financial tool, visit ETF Triangles
Max Rottersman is a founder of FundAnalyze. His opinions don’t necessarily represent the views of ETFguide.com or Yahoo Finance. |
