Do exchange-traded funds (ETF) that operate like rule-based (passive) hedge funds offer attractive performance? In their December 2019 paper entitled “The Performance of Passively-Managed Hedged ETFs”, Jason Cheng, Joseph Fung and Eric Lam examine performance of passively-managed hedged ETFs (HETF) as of the end of 2017. These funds attempt to replicate a hedge fund index (either global macro or long-short equity), generally allocating about 80% to replication 20% to buffer market movements. The study looks at raw returns and alphas relative to a 3-factor (equity market, volatility, interest rate) and more complex 7-factor and 8-factor models of hedge fund returns. They test each HETF individually and equal-weighted portfolios of HETFs. Using month-end prices, net asset values (NAV), assets under management (AUM), and bid and ask quotes for 23 HETFs available at the end of 2017 and monthly hedge fund factor model inputs during January 2008 through December 2017, they find that:
- At the end of 2017, average HETF AUM is $85.1 million, average annual expense ratio is 1.19% and average bid-ask spread is 2.99%. HETFs generally trade close to their respective NAVs.
- HETFs generally perform poorly over the sample period. Most underperform the S&P 500 Index, and some underperform 1-month U.S. Treasury bills.
- HETFs following a macro strategy outperform those pursuing a long-short equity strategy.
- An equal-weighted portfolio of all HETFs generates significantly negative (7-factor (8-factor) monthly gross alpha -0.29% (0.23%), despite positive survivorship bias from ignoring funds terminated during the sample period.
- The poor performance of HETFs derives from high expense ratios and large tracking errors relative to benchmarks.
In summary, evidence indicates that ETFs designed to work like rule-based hedge funds are unattractive for investors.
Cautions regarding findings include:
- Data are somewhat stale for the type of sample.
- As noted in the paper, the sample construction methodology introduces survivorship bias that favors HETFs in aggregate.
- Many HETFs are tiny in terms of assets under management (apparently, for good reason).
See also “Are Hedge Fund ETFs Working?”.