Academic journal article Financial Services Review

Hedged ETFs: Do They Add Value?

Academic journal article Financial Services Review

Hedged ETFs: Do They Add Value?

Article excerpt


Hedged Exchange Traded Funds (ETFs) are relatively new entrants into the ETF industry. These ETFs follow investment strategies similar to those of hedge funds and are attractive to individual investors who are often unable to invest in hedge funds because of high initial investment requirements and longer lock-up periods. These Hedged ETFs offer hedge-fundlike strategies for a fraction of the cost, and zero restrictions around getting into or out of these funds. These ETFs normally have a goal of providing individual investors with access to investment strategies that offer non-correlated returns and diversification benefits. This goal of Hedged ETFs is in contrast with traditional or long only ETFs that try to replicate a benchmark such as S&P 500 or Russell 3000. There are a number of ways ETF can act or replicate Hedge Fund returns.1 The different methods are Direct Approach, Hedge Fund Replication, and Copycat (see Appendix B for a brief description of these three different methods).


This article looks at the merits of holding Hedged ETFs versus holding different (asset) categories of index ETFs. There has been a significant increase in the number of Hedged ETFs. Lot of retail and institutional investors are increasingly drawn to ETFs that aim to mimic hedge-fund strategies. As of December 2014, there were 34 live and 15 dead Hedged ETFs. The assets under management (AUM) under the surviving Hedged ETFs as of December 2014 were $3.42 billion. With the increase in the number of funds and the growth in assets under management it is obvious that investors thought that Hedged ETFs would provide higher risk adjusted returns or benefits from diversification.


This is the first article that looks at the characteristics and performance of Hedged ETFs as an asset class. Previous literature has only looked at hedge funds or alternative or hedged mutual funds (AMFs). Although AMFs are relatively new, there has been some research in this field. Koski and Pontiff (1999) and Deli and Varma (2002) find that the flexibility to use derivatives, sell securities short, and borrow money to create leverage help managers to control expenses, risk, and manage cash flows more efficiently that makes the AMFs appear to be an attractive alternative to standard mutual funds and subject to analysis. Agarwal et al., (2009) were the first to look at the performance of 52 hedged mutual funds over the period 1994-2004. They form a single portfolio of six different categories of 52 Hedged Mutual Funds from 1994 to 2004 and compare them to traditional mutual funds and hedge funds. They find that these Hedged Mutual Funds outperform traditional mutual funds, but underperform similar hedge funds. Kanuri and McLeod (2014) conduct a similar study of 256 AMFs period January 1998 through December 2011using the Carhart four-factor model and the Fung-Hsieh seven-factor model. Their results indicate that most AMFs have not been able to create any value for their investors over this period. Furthermore, the performance of these mutual funds was even worse during the recent financial crisis (October 2007 through March 2009).

This article looks at the performance of surviving as well as dead Hedged ETFs since their inception and compare them to U.S. stock market (IVV), Aggregate bond market (AGG), Total World Ex U.S. (VEU), Real estate market (IYR), and Commodities market (DBC). We compare the performance of Hedged ETFs to different index ETFs for an equal comparison or compare performance after expenses. Elton, Gruber, and Blake (1996) find that previous mutual fund studies suffered from survivorship bias as funds that merge or die have worse performance than funds that do not and failing to account for survivorship bias will lead to higher risk-adjusted returns for mutual funds. Excluding dead ETFs can lead to similar problems. Therefore, dead ETFs were included in the analysis to control for survivorship bias. …

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