The Trouble With Hedge ETFs It can be frustrating trying to mimic loosely regulated hedge funds within closely regulated exchange-traded funds. By CRYSTAL KIM October 28, 2017 Getty Images Hedge funds, which largely have been a losing proposition in this bull market, are, on average, getting closer to putting up market-like returns. But investors looking for alternative strategies in the exchange-traded fund format will continue to be disappointed. Equity-based hedge fund strategies, which have fared the best among alternative strategies, returned 9.6% this year through September, according to research firm HFR. The Standard & Poor’s 500 index, with dividends reinvested, was up 14.2% in that period. ETFs by Category That style of investing is working in mutual funds, too. Of the 87 alternative mutual funds with at least $300 million in assets and a three-year track record, long-short stock funds were among the best performers. One even beat the market. It’s easier to generate excess return when stock correlations are at multiyear lows, meaning that prices of most shares aren’t moving in tandem. As a result, stock-picking is back in vogue. ETFs now account for less than 25% of daily trading value on exchanges, a three-year low, while stock trading has hit a three-year high, according to Credit Suisse. Alternative ETFs, however, haven’t taken off. The strategies can be hard to implement in an exchange-traded fund, the costs remain relatively high, and even funds with longer track records have failed to gather much in the way of assets. Of the 78 alternative ETFs (leaving out those using volatility, inverse, or leveraged strategies that mark them as trading, rather than investing, vehicles), three had beaten the S&P 500 through September.AlphaClone International(ticker: ALFI),AlphaClone Alternative Alpha Portfolio(ALFA), andFirst Trust Dorsey Wright People’s Porfolio(DWPP)—are long/short stock funds, and have less than $30 million in assets. AlphaClone International is two years old; the others have five-year track records. Morningstar’s Ben Johnson says that alternative ETFs seem stuck in a rut, in part because they’re not very good. “You’re getting a watered-down original when you move a hedge fund strategy in an unregulated vehicle into a 40-Act indexed fund,” Johnson says, referring to the 1940 legislation that helps govern such funds. The AlphaClone ETFs aim to mimic the stock portfolios of famous hedge fund managers by using quarterly holdings disclosures. They also can load up on derivatives as a fail-safe when the market dives. When the S&P 500 falls below its 200-day moving average at the end of any month, Alternative Alpha will short the S&P 500, and the International ETF will short the MSCI EAFE. But if stocks bounce back quickly, the ETFs can’t react fast enough to capture the gains. The hedges will no longer be a feature by year end. The First Trust Dorsey Wright People’s ETF is also a stripped-down hedge fund strategy. The ETF buys one- to three-month Treasury bills when they show greater relative strength than stocks. But when stocks outperform, the ETF buys a Nasdaq US 500 Large Cap index, either capitalization- or equal-weighted, whichever is performing better. Today, it’s in the latter. Two-thirds of alternative ETFs have track records going back to just 2010, and therefore haven’t been tested throughout a protracted downturn. Johnson warns that, the alternative ETFs that seem to be beating the market could just indicate that their performance is correlated with that of stocks—which is not necessarily what you want from an alternative investment. For those seeking a more market-neutral approach, actively managed mutual funds are still the best options. Email:editors@barrons.com Follow@crystalkimmm http://www.barrons.com/articles/the-trouble-with-hedge-etfs-1509157235