Hedge funds can deliver above-average returns to investors who are comfortable taking more risk in their portfolios. Aside from the fact that they don’t always deliver, there’s just one catch: Access to hedge fund investments is often limited to high-net-worth and ultra-high-networth individuals. Enter the hedge fund exchange-traded fund (ETF), which aims to mimic the investment strategies of hedge funds. This type of fund is much more accessible to the everyday investor, though there are some pros and cons to keep in mind when adding them to your portfolio. A financial advisor can help you determine if a hedge fund ETF is a wise addition to your portfolio.
Hedge Funds, Explained
To understand a hedge fund ETF, it first helps to understand hedge funds and hedge fund strategies. A hedge fund is essentially a pooled investment, similar to a mutual fund. But the difference between these funds and other mutual funds is how they invest.
Hedge funds, which are normally actively managed, typically go beyond simple investments in stocks and bonds to hold a variety of alternative investments. For example, hedge funds may concentrate solely on commodities, real estate, derivatives or currencies. A hedge fund manager oversees the buying and selling of fund investments and utilizes one or more hedge fund strategies.
For example, there are hedge funds that only go long or short on equities and others that concentrate on leveraging investment opportunities when two or more companies merge. While hedge fund strategies can work differently depending on what the fund invests in, the end goal is usually the same: to produce returns for investors that outpace the market average.
What Is a Hedge Fund ETF?
A hedge fund ETF is an exchange-traded fund that seeks to replicate the trading activity and investment strategy of a traditional hedge fund. Exchange-traded funds are essentially a pooled investment similar to a mutual fund but with one key difference. While mutual fund transactions close out at the end of the trading day, ETFs can be traded all day long just like stocks.
Hedge fund ETFs pursue hedge fund strategies to try and create the same type of returns for investors as a regular hedge fund might provide. So again, you can have hedge fund ETFs that apply any of the following strategies:
- Long/short equity
- Merger arbitrage
- Global macro, in which investment decisions are based on global economic trends
- Event-driven, in which the goal is to capitalize on a specific event such as a liquidation or bankruptcy
- Distressed debt, which involves buying up debts of struggling companies at a discount
A hedge fund ETF can also apply an indexing strategy, in which the aim is to mimic the performance of a particular hedge fund index or benchmark. This is similar to how traditional index funds, which may track the S&P 500 or Nasdaq Composite, operate. Here, the goal is not necessarily to beat the market but to match the chosen benchmark’s return profile.
Hedge fund ETFs can also seek to match the returns of a hedge fund by investing in the same things the fund does. When a hedge fund publishes a quarterly report of its holdings, a hedge fund ETF can analyze holdings and make the same or similar investments. This can be tricky, however, since these reports may not offer insight into where a hedge fund plans to invest next.
Pros of Hedge Fund ETFs
Hedge fund ETFs can offer two main advantages to investors. The first is accessibility. Traditional hedge funds are usually exclusive to higher net worth accredited investors. An accredited investor is someone who meets SEC guidelines regarding net worth and/or income. These funds may have minimum investments in the five-, six- or even seven-figure range, putting them out of reach for the average investor.
With a hedge fund ETF, on the other hand, it’s possible to invest with a few hundred or a few thousand dollars, depending on the fund’s minimum investment. You can find hedge fund ETFs offered through online brokerage accounts and depending on the brokerage, you may be able to trade them with zero commission fees.
The other upside of hedge fund ETFs is the potential to generate above-average returns in your portfolio. Hedge funds are by nature a riskier investment since they rely on alternative investment strategies. But if those strategies pay off investors reap the benefits through significant gains. Hedge fund ETFs make it possible for a wider number of investors to realize gains from hedge fund strategies.
Cons of Hedge Fund ETFs
While there are some positives associated with hedge fund ETFs, there are a few downsides to consider. Risk is certainly an important factor since hedge fund ETFs can be riskier and more volatile than other types of ETFs or mutual funds.
Hedge fund strategies may lead to higher returns but there are no guarantees. If a hedge ETF’s bets don’t pan out then you could realize a loss, rather than a gain on your investment. For that reason, it may be wise to limit how much of your portfolio you allocate to hedge fund ETFs.
The other potential drawback is cost. Every ETF has an expense ratio, which is what you’ll pay to own the fund each year expressed as a percentage of assets. Since hedge fund strategies typically require active vs. passive management, you may be looking at a higher expense ratio to invest in one of these ETFs. Higher costs may be justified if a hedge ETF produces the returns you’re expecting but again, there are no guarantees.
How to Invest in a Hedge Fund ETF
The easiest way to invest in hedge fund ETFs is to open an online brokerage account if you don’t have one already. Online brokerage accounts are generally taxable accounts, though you can also open a traditional or Roth individual retirement account with an online broker. When choosing an online brokerage account, first check to ensure that hedge fund ETFs are an investment option offered through the platform. Then check to see what type of commission or fee you’ll pay, if any, to trade them.
Once your account is open, you can begin comparing individual hedge ETFs. As you evaluate investment options, consider what hedge fund strategy or strategies individual ETFs use. Also, consider the fund’s track record and performance as well as its expense ratio to help you narrow down the list.
The Bottom Line
Hedge ETFs are an investment alternative you might consider if you like the flexibility of being able to trade ETFs and you’re interested in the possibility of earning higher returns. Understanding the risks and costs involved is important for ensuring that a hedge fund ETF is appropriate for meeting your short- or long-term investment goals.
Tips for Investing
- One of the most important ways to ensure that you don’t take on an excessive amount of overly volatile or highly risky investments is with a proper asset allocation. A free easy-to-use asset allocation calculator can help you keep your portfolio properly balanced.
- Talk to a financial advisor about hedge fund ETFs and whether it makes sense for you to invest in them. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/Tashi-Delek, ©iStock.com/G0d4ather, ©iStock.com/Juanmonino