The (Under) Performance of Hedge Fund ETFs

Abstract

As exchange-traded funds (ETFs) have become an important investment tool to hedge risk, an appealing new type of ETF has been developed called “hedge fund ETFs” (HETFs). HETFs give retail or long-only institutional investors an opportunity to invest in various hedge fund strategies but with the advantages that ETFs offer, such as instant liquidity and transparency. The authors investigate the performance of HETFs and find that they broadly underperform hedge fund benchmarks and exhibit subpar risk-adjusted returns. The authors’ analysis reveals that much of this underperformance is explained by a lack of prior hedge fund experience by HETF managers and heavy investment by HETFs in other ETFs. The sample of HETFs conditioned on managers with hedge fund experience and little investment in other ETFs does not exhibit the same underperformance. The authors’ results highlight two factors investors should be cognizant of when considering these new investment products—manager experience and investment in other ETFs.

TOPICS: Exchange-traded funds and applications, real assets/alternative investments/private equity, manager selection

Key Findings

• • Since 2009, hedge fund ETFs have underperformed risk models by 2.14% per year and benchmarks by 4.41% per year.

• • Most of the underperformance of hedge fund ETFs appears to be explained by two factors—lack of manager skill and heavy investment in other ETFs.

• • Investors looking to invest in hedge fund strategies—such as long-only institutional investors and unaccredited investors—should look for hedge fund ETFS that have managers with previous hedge fund experience or for funds that do not predominately invest in other ETFs.