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In recent years, exchange-traded funds (ETFs) have become an increasingly important tool for investors looking for a low-cost method to hedge risk. In tandem with those changes, ETFs have become increasingly exotic over time. For example, in 2009 leveraged ETFs and volatility ETFs were first introduced via funds, such as the Proshares UltraPro S&P 500 and the iPath S&P 500 VIX Short-Term Futures ETN (VXX).1 In March 2009, the IQ Hedge Multi-Strategy Tracker ETF (QAI) was launched and another important and quite overlooked new class of ETF was introduced: the hedge fund ETF (HETF). HETFs are particularly intriguing as these funds attempt to mimic hedge fund strategies while still offering the liquidity, transparency, and potential tax and regulatory advantages that ETFs offer.
For retail investors and long-only institutional investors seeking hedged strategies, HETFs have several advantages that make them potentially superior to other similar investment options, such as hedge funds or hedged mutual funds. Compared with hedge funds, a primary benefit of HETFs is their availability to unaccredited investors who are typically restricted from investing in hedge funds. In addition, since ETFs are closed-end vehicles, investors can sell their shares of a HETF on the open market at any time the market is open. But, many investors in hedge funds experience a “lockout period” in which their investment cannot be redeemed without manager approval, and mutual funds can be redeemed or purchased only at a daily closing net asset value. In addition, ETFs typically offer lower management fees than hedge funds and almost always provide greater transparency to investors. Furthermore, ETFs offer tax advantages to certain investors (Miffre 2007; Agapova 2011). Finally, ETFs more easily use leverage and short selling than do mutual funds. Although mutual funds and ETFs are bound by regulations in the Investment Company Act of 1940 concerning use of leverage, which is limited to 1.5, mutual funds typically invest in equities only and limit their short exposure in their prospectus.2 However, ETFs, upon the approval of the Securities and Exchange Commission (SEC), can use derivative securities to obtain exposure to the underlying asset well beyond 1.5.
The practical and regulatory advantages of ETFs over hedge funds or mutual funds, along with the strong demand for alternative investments, have generated...