Trading Like the Hedge Funds Do

With the market starting the year quite well — S&P 500 was up 4% as of Wednesday’s close — we might be tempted to assume that   the rest of 2012 will go as smoothly, and start allocating higher   percentage of our portfolios to U.S. equities. After the past year,   which resulted in zero returns for the S&P 500, who can blame us?   It’s also an election year, so things we may certainly feel things are   looking rosy.

That might well be the case, but of  course we will not know for sure  till the end of the year. As for myself, I feel there are  still too  many macro unknowns left to be resolved, so I remain quite  cautious.

With that in mind, I would like to suggest a  different tact than  simply “increasing allocation to equities.” I am  talking about  alternative strategies in general, which can be pursued  through  alternative ETFs. I’m focusing on these, and not  on mutual funds, for a  few reasons: ETFs are transparent, they trade  intraday, they provide  better liquidity, they have lower cost and they  may provide tax  advantages.

As for alternative ETFs,  specifically, my major reason for starting  to look at these is that they  provide prudent portfolio  diversification. As I have written before,  major endowment funds — at  such universities as Harvard and Yale — make room for alternative  strategies among several other asset  classes (equities, fixed income  and real assets, such as commodities and  real estate). As of September,  in fact, Harvard’s endowment fund shows a 16%  allocation to  alternative assets, or absolute return.

What  characterizes alternative assets is that they typically have  low  correlation to broad stock indices, and they  aim to provide low  volatility. They also make for an excellent portfolio-diversification  tool, meaning that high-quality alternative-strategy  funds provide for  better risk-adjusted returns. In other words, to a  large extent  alternative funds will reduce your volatility, while only paring back on  returns to a comparatively slight degree.

These  alternative strategies provide for low correlation and lower  volatility  because they use hedging techniques — just like hedge funds  do. A  typical hedged approach, aptly named the long-short strategy,  will  involve simultaneous long and short exposure on certain  securities. Some  of these aim to deliver alpha from both the long and  short positions,  while others aim to do so from long positions, while  hedging with short  positions.

So, now — presuming you like the idea of  diversifying your  portfolio and reducing your risk — where do you find  more information  about these ETFs? There are several good sources, but I  especially like  ETFdb.com and IndexUniverse.com. In fact, I’ve used  both to put  together a combination of alternative and long/short ETFs,  and  ultimately I came up with a list of 21 funds:

Long/Short ETFs

Source: ETFdp.com and IndexUniverse.com

This  is my first cut, based on the criteria I have established  above.  Although a 21-name list might seem daunting, it is actually not a  very  long list, relative to other type of asset classes from the  endowment  category list.

In any case, with those choices  established, the next step is  deciding which particular alternative ETF  to add. The criteria you use  could be limiting yourself to an equity or options ETF, or to one that   employs active management or follows an index. You could also pick a  fund that’s market-neutral  or dollar-neutral, one that’s factor-driven  or goes on fundamental  valuations, to name just a few options here.

Regardless  of what you choose, though, I continue to strongly  believe in prudent  portfolio diversification by allocating to different  asset classes.  Adding alternative long/short ETFs will go a long way  toward achieving  that goal.

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At the time of publication, Gurvich and clients of The Rockledge Group were long SSAM, of which Gurvich is the portfolio manager.