It’s been a funny year.   We started out with most commentators bullish on equities and bearish on bonds and that is still pretty much the consensus view.   Unfortunately, the markets themselves don’t seem to recognise this and, with a few exceptions, equities have generally had a dull year so far, while bonds have enjoyed a reasonable rally.

While some local markets such as the US have moved upwards, the equity returns seen by UK-based equity ETF investors have been hit by Sterling strength.   This has also hit overseas earning of UK companies and partly explains the muted FTSE100 performance.

The pound may continue to strengthen if UK growth carries on at the current rate but dilution from currency movements so far this year highlights the benefits of currency hedged ETFs which I have discussed in a previous article. Another reason for slow progress in equities is disappointment with the overall trend of global growth and the failure of the Eurozone economy to build up momentum.

Against this backdrop it is hard to get too excited about the near-term prospects for developed markets and we have been switching into selected emerging and Asian markets using some of the ETFs I have written about.

Overcoming fixed income hurdles

At Charles Stanley Pan Asset we have always recognised that there can be limitations when using trackers to get fixed income exposure and took action earlier this year to address the problem.   The range of fixed income ETF products listed in the UK is still relatively limited, compared to ETPs tracking equities and other asset classes.   We find that bond ETFs tend to lump together bonds of particular maturities or credit ratings, limiting our ability to nuance bond sensitivities in portfolios.   To overcome this we have used our PFS PanDEFENSIVE fund as a low cost way of creating a quasi-index of short-to-medium maturity high grade corporate bonds as well as a few very short-dated, but good quality, high yield plays to spice up the return without bringing in too much additional risk.

Since we know the yield to maturity for each of the hundred or so underlying holdings we know that we can rely on this overall return if we hold them to redemption – not always the case with a tracker where the holding may be rebalanced or sold out of before maturity, missing out on a good low-risk source of return.   Using this approach we expect to get a return of over 3% with low volatility and limited sensitivity to interest rate rises.

The hunt for diversification

To address the problem of dull equities and increasing geopolitical risk we wanted to introduce more diversification into our model portfolios.

We considered commodity, hedge fund and private equity ETFs; however, we don’t feel that this is the optimal moment to buy commodities due to the prospect of bumper harvests, a plentiful supply of crude oil and subdued demand for industrial metals around the world.   That situation may soon change if world growth picks up and I have given some good ways to buy into commodities in an earlier article.

Hedge funds

That leaves hedge funds and private equity.   Having visited hundreds of hedge funds during my earlier career as a fund of hedge fund manager, I do have some strong views on the sector.   They haven’t performed particularly well since the credit crunch and have fallen out of favour with private investors, even if institutions are continuing to buy.

The big problem with them has always been the charges.   It is only possible to add so much return with ‘alpha’ (the outperformance from stock selection) and many fail to add any.   In the past, hedge fund managers could rely on exploiting ‘beta’ (the return from the overall market) by using high levels of leverage, or borrowing, which were not available to most investors, but amplified their returns.   They were helped by plentiful sources of credit, generally benign bond and equity markets through to 2008 and more pricing anomalies to exploit in the days when they could dominate certain sectors and sub-sectors in the market.   A strong flow of mergers and acquisitions also helped.   All these factors helped them to produce returns which were multiples of those available from the underlying asset classes and justified their high fees.

Over the past few years returns have been much lower and look poor after deducting costs of well over 2% per annum. The extra level of costs which funds of hedge funds or ETF hedge fund trackers bring can mean you make no money at all and is our main reason for continuing to avoid the asset class, even though it can help to reduce volatility.

For those of you who are not deterred and would like to invest via an ETF there are three main choices; two from db x-trackers and one from UBS.   db x-trackers offers the db Hedge Fund Index ETF which tracks a multi-asset pool of hedge funds which are managed on its platform, while its Equity Strategies Hedge Fund Index ETF does what it says on the tin.   Meanwhile, UBS has an ETF which tracks the HFRX Global Hedge Fund Index. The latter is the investible HFR index and should not be confused with the longer-standing HFR index which has many unavailable funds in it and has tended to perform better over time.   Both houses offer these solutions with a TER of between 0.6% and 0.9% per annum plus swap charges for the synthetic replication.   They are therefore not cheap, but do provide an accessible way to invest in hedge funds and are still less expensive than the typical funds of hedge funds.

Private equity

Finally, there is listed private equity, which we already hold in portfolios. Put simply, private equity is just a geared or leverage form of public equity and should be expected to outperform when the markets are going well and when there is plenty of corporate activity in the form of takeovers and mergers.   Underlying exposures of the main indices are skewed towards the developed markets but we expect the sector to outperform the major equity markets, which seem to have lost momentum.

These ETFs are liquid because they do not track highly illiquid underlying private equity positions, but instead follow the management companies that invest in them such as Blackstone, KKR and 3i Group. These companies continue to enjoy the management fees even when times are hard, but in addition pick up the ‘carry’ from successful sales when things pick up. Both iShares and db x-trackers provide ETFs if you are interested in buying into this sector. The db x-tracker product is slightly cheaper at 0.7% p.a. for a synthetic ETF, while iShares comes in at 0.75% p.a. and is physically replicated. Each follows a different index with the iShares ETF more exposed to the US and the db x-tracker one more Europe focussed.

Using products such as these to increase portfolio diversification is very worthwhile and can help to reduce volatility as well as improving returns.   It is also worth looking at some of the ‘smart beta’ ETFs, which I have covered before. Whatever you decide to do, remember that it is your overall risk-on/risk-off decisions coupled with keeping costs as low as possible that is likely to make the most difference to your long term returns, rather than moving the deckchairs around at the periphery of your portfolio.

Charts and Tables: Hedge Fund ETFs have delivered disappointing performance in recent years