Hedge funds are operating inside ETFs, with some big risks and potential benefits for investors

• The number of exchange-traded funds employing what are often described as hedge fund-like strategies continues to grow.
• Investment strategies uncorrelated with the stock and bond market can help investors generate market-beating returns, but these funds vary widely in approach and can have relatively high fees.

It's not exactly a new trend, but more hedge fund-like strategies continue to be launched as ETFs, promising investors returns uncorrelated to traditional stock and bond market indexes.

For investors, the key is understanding the exact investing style of each (that can vary widely under a general “hedge fund” brand); how its differs from traditional stock and bond investments; how much it charges in fees, and whether there are equally good, and cheaper ways, to seek diversification in the market over the long-term.

Historically, hedge fund strategies were limited to the ultrawealthy and institutional investors who could meet high investment minimums, but that has changed. There is now over $5 billion in assets under management in ETFs using some form of hedging and aiming for uncorrelated, diversified returns, according to ETFAction.com data.

These products are often classified as alternative absolute return strategies, offering investors an alternative to the stock or bond performance tracking the big market benchmarks, such as the S&P 500 Index and Bloomberg Aggregate Bond Index. Hedge fund ETFs can range from event-driven strategies, to multi-strategy portfolios and managed futures funds.

The newest are from the Unlimited lineup up ETFs, founded by a former investment committee member at the world's biggest hedge fund, Bridgewater Associates. It recently launched global macro, long-short and managed futures strategies, all charging 0.95%. While no comparison can be made between what these funds are trying to do and the goal of an S&P 500 index fund like Vanguard's VOO, investors do pay a lot more for the access to alternative investment strategies. Vanguard's S&P 500 ETF has an expense ratio of 0.03%.

Mike Akins, CEO of ETF Action, says that these strategies can be unique, and useful. “The idea of most of these strategies is you're going to get uncorrelated, diversified returns. So, you can get an absolute return strategy that's supposed to perform in all market cycles,” he said. “You're creating kind of a diversification tool within your overall portfolio, the opportunity to generate solid returns, but in an uncorrelated fashion to your traditional equity and bond markets,” he added.

Funds that track major market benchmarks such as the Russell 1000 or S&P 500 should all have very similar performance, so choosing one of these ETFs versus another across all of the ETF managers that offer versions of them won't influence performance much, if at all. But with managed futures, event-driven or multi-strategy funds, Akins said there can be a huge divergence in returns across funds and over different time periods.

He said a review of the recent performance from this category shows that some do produce negative correlations to the broad equity markets, but others purporting to achieve uncorrelated returns have extremely high correlations to major market benchmarks. “All these different strategies, even though they have very similar sounding names, the results and the way they're going about trying to achieve results are very, very different,” Akins said.

That leads Akins to conclude that in most cases, these kinds of ETFs are better left for professional investors to consider. “Generally speaking, they're probably best used in the hands of a financial professional that understands how they're putting it into a client's portfolio,” he said.

Strategas senior ETF and technical strategist Todd Sohn says that while the fees are higher than many core ETFs, accessing these strategies within a retail fund wrapper is the only way most investors can gain access to the more sophisticated trades. “Access is a pro, and then you're also getting what should be an uncorrelated strategy to your typical 60/40 stock and bond portfolio,” he said. “It'll move in a different direction on a given day. It'll help offset, maybe, any losses.” He added that while there are no guarantees it can lead to outperformance versus tradition portfolio structures, “ideally, it acts as a little bit of a push in certain environments.”

But Akins says that transparency is a factor, as these hedge fund-like structures can be hard for most investors to understand. “They're running very unique strategies. It really does become more of the due diligence of the manager selection process versus just understanding what's being done and held inside of the portfolio like a normal ETF or bond portfolio,” Akins said. “The level of due diligence that needs to be done is much higher for this type of strategy,” he said.

Sohn said the complexities inherent in these funds is a factor that investors need to educate themselves on before including in a broader portfolio mix. “There's a little bit more nuance in them, and they can go long and short, they can play in very different asset classes, like commodities.” Sohn said. “So there needs to be a little bit of an education component, and that complexity can sometimes scare people off,” he said.

Akins said it's fair to consider whether alternatives can take the place of traditional fixed income as a diversifier at a time when investors are concerned about the bond market's ability to serve in its traditional role, say up to 10% to 15% in an alternative bucket. “But if you're going to do that, you really, truly need to understand how it reacts,” he said. “Is it truly providing you with uncorrelated returns? Is it making the overall risk in your portfolio decrease? Because if it's not, you're paying a lot,” he added.

The average expense ratio for the alternative ETF space tracked by ETFAction.com is 92 basis points (0.92%), with some portfolios a bit below that but others well above 1%, even 2% in some cases, Akins said. “Unless it's truly delivering uncorrelated returns across the market, it's not worth the extra money,” he said.

He stressed that this does not mean alternative strategies are like some “Wild West” in the ETF market.

“They're defined strategies. They're defined categories. But the way you go about implementing a managed future strategy, or the way you go about implementing a multi-strategy portfolio, putting all those different alts ... event-driven, managed futures, global macro [together], the way you go about doing that is very different for everybody,” he said.

Managed futures funds, for example, are all over the place in returns year-to-date, with some ETFs in the space up as much as 3% and others in the same category down more than 10%.

“There's a reason those things have been kind of isolated to accredited investors or the wealthy,” Akins said of the history of the hedge fund industry.

It is not just the complexity of the strategies, but the fact that they serve a greater role in protecting existing wealth from market downside than growing wealth. For the average investor looking to grow their wealth over the long-term rather than protected the wealth already accumulated, these strategies often do not make as much sense, Akins said.

Broad-based bond ETFs and low-volatility stock ETFs might be enough for most investors as a way to diversify risk over the long term in portfolios.

“If I'm a 30-year-old looking to invest in the markets, and I just want I know it's going to be invested in my IRA or my taxable brokerage account for the next 30 years, these are not going to provide a benefit,” he said. “For somebody with accumulated wealth, and the most important thing is to create a portfolio that protects the downside, then that's where these types of strategies really start to play a role in a portfolio. But it's not a YOLO [you only live once] type product,” he said.