Criticisms of QAI, the New Hedge Fund Exchange Traded Fund (ETF) ~ market folly

Tuesday, March 31, 2009

Criticisms of QAI, the New Hedge Fund Exchange Traded Fund (ETF)

After all the crazy exchange traded funds (ETFs) that have been released over the past few years, we thought we had seen it all. But, leave it to IndexIQ to take it to the next level . They've released the IQ Hedge Multi-Strat ETF, ticker QAI. This new ETF is not a hedge fund itself and does not invest in hedge funds. However, it seeks to replicate their hedge fund multi-strategy index, where they use long/short equity, global macro, market neutral, event-driven, emerging markets, and fixed income arbitrage. We thought this was an interesting offering seeing how we track hedge fund portfolios here at MarketFolly. But, upon further examination, we found a few flaws with this vehicle.

Basically, IndexIQ has laid out exposure to all the major hedge fund strategies and will try to seek solid returns based on a collection of these strategies. What is interesting about this ETF is that it is investing in other ETFs as part of its strategy. Some of their top holdings include: iShares Aggregate Bond (AGG): 23.91%, iShares Barclays 1-3 Year Treasury (SHY): 18.31%, and iShares Emerging Markets (EEM): 11.04%. The immediate criticism here would be investors asking, "Why do I need to use this ETF when I can just look at your top holdings and allocate my money appropriately to the ETFs QAI is using?" And, that makes perfect sense. (After all, IndexIQ will post daily holdings to their website and will rebalance on a monthly basis). Investors could simply buy the same ETFs QAI is invested in.

The flaw in this criticism would be the fact that ETFs invest in a myriad of holdings and so you would have to truly stay on top of all the holdings, not just the top few, in order to truly replicate the same performance as QAI. And, since QAI rebalances monthly, you'd also have to rebalance your holdings monthly (not to mention all the trading commissions you would incur with all the buying & selling). This brings us to our first point: Instead of an exchange traded fund (ETF), QAI is more like an exchange traded fund of funds replicating a hedge fund of funds strategy.

The current weightings in QAI are split 33.33% across the following strategies: equity market neutral, event-driven, and fixed income arbitrage. It also has a -16.67% position in long-short and everything else is comprised of global macro and emerging markets. The ultimate problem here is that QAI doesn't have any short positions. But, IndexIQ says they have dealt with this by investing in inverse ETFs to allocate short exposure. This is a giant red flag, considering how leveraged inverse ETFs are horrible at tracking their indexes over a longer period of time. As daytrading vehicles, they're fine. But, the minute you hold them overnight (past the inverse ETF's daily reset), you're potentially screwed. Here's the list of QAI's holdings and portfolio breakdown, courtesy of IndexUniverse. This closer look reveals a problem:

  • 72.79% fixed income, including 32.73% in broad-based bond indexes; 27.71% in short-term Treasuries; 10.54% in junk bonds; and 1.81% in TIPS
  • 13.33% in emerging market stocks, the only long equity position in the portfolio
  • 9.47% in commodities and currencies
  • 4.41% in various inverse funds
(click to enlarge)

As you will note in their complete holdings list above, QAI holds a couple of Ultrashort ETFs. We wanted to show why investing in these ultra-short ETFs is a bad idea and have chosen one of their holdings, SRS, for the example. QAI is invested in SRS, the Ultrashort Real-Estate ETF. SRS seeks 2x the inverse daily performance of IYR, the underlying real estate index ETF. Now, this seems all 'fine and dandy,' but here is the problem we've highlighted: 2x inverse ETFs do not track their indexes accurately over time. Let's look at the year to date performance of SRS and IYR, the index SRS seeks to replicate:

(click to enlarge)

As you can see, IYR is -35.6% ytd and SRS is +20.3% ytd (as of March 30th, 2009). And here is the glaring problem. SRS is theoretically supposed to be 2x in the inverse performance of IYR. So, if IYR was -35.6%, then SRS should have returned +71.2%. Yet, we see that in reality, SRS is up only 20.3%. So, we obviously have a problem. And, the problem is the fact that QAI has chosen ultrashort ETFs as the proxy for their short exposure. The problem with these ultrashort ETFs is they seek daily replication of their indexes and as such, reset on a daily basis. The compounding is then skewed over time (hence the vast error in tracking between IYR and SRS over extended periods of time). Ultrashort ETFs are appropriate as quick trading vehicles. They are not appropriate as investments.

Now, the 'positive' of this situation (if you even want to call it that), is that QAI has only allocated 0.46% of its assets to SRS (and 4.41% overall to inverse funds). So, the overall exposure to these tracking-error landmines is small. But, you're still exposed. Given the fact that QAI rebalances monthly, you'll have to be on the lookout as they could potentially increase Ultrashort exposure on any given month.

Secondly, we want to address the issue of expense ratios. Not only are you paying QAI an expense ratio (fee) to essentially allocate your money to other ETFs (with underlying expense ratios of their own). But, you're also paying QAI an expense ratio to allocate your money into proxies that don't even give you proper index tracking (i.e. SRS & other Ultrashorts). You are being passively 'double dipped' on fees. SRS charges an expense ratio, and then QAI charges you an expense ratio to invest you in SRS (and other ETFs). Maybe its just us, but it seems as if the 'cons' are outweighing the 'pros' thus far. Let's move on to the next potential flaw: the fact that it's more of a fund of funds ETF than an outright hedge fund ETF.

There could be some confusion when investors see that QAI is deemd a 'Hedge Fund ETF.' We think a more appropriate title is a 'Fund of funds ETF.' IndexIQ somewhat addresses this issue by labeling QAI a 'Multistrategy Hedge Fund ETF.' This is politically correct, since QAI technically invests in multiple hedge fund strategies. However, we think the fund of funds terminology is more appropriate and here's why: Not only does QAI invest in numerous hedge fund strategies (like a fund of funds), but it also charges double the fees. QAI will charge a 0.75% expense ratio, which is right around the norm for typical ETFs. But, since QAI is investing in other ETFs, you will also be charged those underlying ETF expense ratios passively. (For instance, QAI is charging you 0.75% to invest in vehicles such as SRS, which has its own underlying expense ratio of 0.95% that you will also be passively charged).

A hedge fund of funds essentially does the same thing, as they charge you a fee (slightly over 1% or so) to diversify your money into numerous hedge funds who also charge underlying fees (2% management and 20% performance fee). The upside of QAI (if you want to call it that) is that you won't be charged the astronomical fees most hedge funds charge. Instead, you're 'only' paying expense ratios of around 1%. But, the point is that QAI is still charging you a second set of fees passively, through the investments they purchase (other ETFs). Something just doesn't sit right when you think about how you're paying IndexIQ an expense ratio to invest you into other vehicles which have an underlying expense ratio themselves.

Its interesting to note that this isn't the first vehicle that IndexIQ has created, as their IQ Alpha Hedge Strategy Mutual Fund was -4.1% for the year. So, performance wise, they seem to be doing alright with that vehicle. We'll have to see if QAI has success on a relative basis and how accurately it replicates the index it seeks to track.

The vehicle itself (QAI) is an interesting idea as it could potentially give hedge fund strategy exposure to investors who typically do not have access to such alternatives due to regulations and restrictions. So, we definitely applaud the innovation. But, in its current incarnation and nomenclature, QAI has some problems. It is not an ETF, but rather an ETF of other ETFs (or, as we like to call it, an exchange traded fund of funds). And, instead of being charged only one expense ratio, you will passively be 'double-dipped' with fees of the underlying ETFs they invest in, in addition to the expense ratio QAI charges. While QAI's current designation as a "Hedge Fund Multi-strategy ETF" may be politically correct, we think it should be designated a "Fund of funds ETF."

Lastly, and probably most importantly, QAI will not be short-selling. A hedge fund in the true sense of the definition has to have short exposure. And, the folks at IndexIQ know this. The problem is, they've chosen to address this issue by investing in shortselling vehicles that were created for trading. Ultrashort ETFs are great for quick trades. They are horrible for investments. They do not track their indexes well over time and therein lies QAI's main problem. Sure, QAI will collectively only have slight exposure to Ultrashort ETFs (although it will change monthly). But, the fact that they have any exposure at all is a problem.

In the end, this is yet another addition to the world of interesting ETFs. And, since we generally like to stray away from leveraged ETFs as investment vehicles, we'll watch QAI from the sidelines for now and will stick to tracking hedge fund portfolios for the time being.

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