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Is a hedge fund-style investment right for you?

Former Bridgewater Associates executive Bob Elliott’s plan for exchange-traded funds (ETFs) that employ hedge fund strategies has sharpened the debate about whether retail investors should have access to such approaches.

The answer broadly is yes, though mostly for investors who understand how these strategies work within a broader portfolio.

A second question is whether such sophisticated active management belongs in an ETF format versus an open-end public mutual fund. We’ll need a short dive into history to understand these debates better.

Public open-end mutual funds were created in the 1940s by the United States Securities and Exchange Commission (SEC), which forbade or discouraged leverage, derivatives and concentrated positions, making it pretty much impossible to beat the market.

More significantly, it forbade performance fees. The result was excessive management fees and returns that consistently lagged the market. The two types of public mutual funds that helped investors – index funds and money market funds – were initially resisted by the SEC.

These shortcomings pushed wealthy investors into private funds. Eventually named “hedge funds”, although not all of them hedged, the funds lived by performance fees rather than management fees, thus prioritising returns over sales. In fact, many of the most successful were closed to outside investors and ran only for the benefit of founders and employees.

ETFs were another SEC creation, designed to protect markets rather than to serve investors. A major problem in the 1987 stock market crash was that people trading baskets like the S&P 500 used futures which settled in a different system and city than individual stock trades. The SEC wanted baskets of stocks that settled in the same market as the underlying securities.

The rules were clear in the 20th century. Public mutual funds ran traditional long-only strategies, mainly picking which stocks or bonds to buy. Hedge funds could run any strategy, but could not be advertised, nor sold to more than a few wealthy investors. ETFs were passive baskets of stocks meant for traders.

The lines have blurred in the 21st century. Rules for public mutual funds have loosened to the point where many traditional hedge fund strategies can be offered, such as risk parity, managed futures, global macro, merger arbitrage and long-short equity.

ETFs have broadened from passive baskets to the most active and sophisticated strategies, and are pitched to long-term investors as much as traders. Hedge funds have come to rely on institutional investors – pension funds, endowments and sovereign wealth funds – more than wealthy individuals.

There’s no doubt hedge fund strategies can help individual investors – although whether most use them wisely is another question. Some strategies like risk parity are designed to offer long market exposure like S&P 500 index funds, but with better risk/return ratios due to more diversification. These are generally superior to mixes of stock and bond index funds.

Other strategies such as merger arbitrage and global macro are designed to provide return boosts with little correlation to stocks and bonds. Since small allocations add almost no risk to a stock/bond portfolio, any return above the risk-free rate helps a portfolio. Finally, some strategies provide diversification via access to non-traditional asset classes such as managed futures.

Given that at least some hedge fund strategies can help at least some retail investors, the next question is whether the public mutual fund or ETF format is superior. The products are more similar than different, and many funds are offered in both wrappers. The choice involves several factors, but at a high level, ETFs make more sense for long-term holders of relatively passive baskets.

ETF investors pay bid/ask spreads and sometimes commissions when they transact. If that’s only every 10 years or so, the costs are minor. No-load public mutual funds can usually be bought and sold without charge, but investors coming in and out cause a performance drag. Over longer horizons, these are usually greater than the in-and-out costs of ETFs. There can also be tax advantages for ETFs held in taxable accounts, and these are greatest for long-term holders of relatively passive ETFs.

Therefore, relatively passive hedge fund strategies meant for buy-and-hold investors pretty clearly belong in the ETF form.

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Paradoxically, ETFs are also right for active traders as they can be bought or sold any time markets are open. Mutual funds transactions are usually limited to once per day and many funds penalise active trading. Active trading of active strategies is no retail game though. It’s one thing to day-trade the S&P 500, quite another to make short-term bets on portfolios whose composition is changing at the same time without your knowledge.

So it seems sensible for retail investors to look at ETF versions of hedge fund strategies they want as permanent portfolio constituents – either core long holdings like risk parity, or diversifiers like managed futures. Aggressive strategies with consistent holdings, like levered ETFs, also make sense for traders, but not for long-term investors.

Most retail investors can do fine combining a low-fee, highly diversified equity index mutual fund like an S&P 500 fund – either public mutual fund or ETF – with a money market fund. They can do somewhat better – albeit with higher costs and more effort – by diversifying into some traditional hedge fund strategies.

Frequent traders though might do themselves more harm than good with ETFs running active-trading hedge fund strategies.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of The Poker Face Of Wall Street.

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