Savvy financial advisors know that a buoyant stock market doesn’t last forever and, consequently, maintain suitable risk profiles in their clients’ portfolios. The challenge today is that the traditional anchors of stability for portfolios – investment-grade bonds – offer paltry yields and have heightened interest rate risk.

Hedge funds, although no panacea, are an option because of their lower volatility and drawdown relative to stocks. Hedge funds, however, have drawbacks.

First, they typically are available only to accredited investors. Second, because hedge funds actively use shorting, leverage and/or derivatives across a range of asset classes, due diligence is paramount and diversification critical. Third, hedge funds are expensive, with fees usually in the “2% and 20%” range. Fourth, a typical hedge fund isn’t immediately tradable; even liquid funds normally require 45 days’ notice and redeem only once a month.

But one option for advisors is an exchange-trade fund (ETF), which ameliorates these drawbacks. Horizons Morningstar Hedge Fund Index ETF (HHF), managed by Horizons ETFs Management (Canada) Inc. and subadvised by Montreal-based Fiera Capital Corp., is designed to replicate, before costs, the performance of the Morningstar broad hedge fund index (MBHFI), hedged to the Canadian dollar (C$).

HHF doesn’t invest directly or indirectly in any hedge funds. The performance of the MBHFI is tracked by using the Nexus hedge fund index replication strategy, which has exposure to liquid futures contracts, ETFs and money market instruments. This strategy seeks the optimal long and short exposure to a variety of asset classes (currency, fixed-income, commodities and equities) in different geographical markets in a manner that strives to mirror the systematic factors driving hedge fund returns.

From May 2012 to July 2014, HHF had an annualized return of 8.9% vs the 13.7% and 18.5% returns of the S&P/TSX composite index and S&P 500 index (hedged to the C$), respectively. Critically, HHF achieved its return with much lower volatility and drawdowns. HHF’s annualized standard deviation of 5.4% compares favourably with the 9.2% and 11.4% standard deviation of the aforementioned indices, respectively, while HHF’s maximum drawdown (based on monthly returns) of -2.7% is much lower than the indices’ -6.1% and -6.2%, respectively.

HHF also has a material diversification effect for Canadian portfolios. This ETF’s correlation during the period to the FTSE TMX Canada universe bond index and the S&P/TSX composite index was zero and 0.29, respectively. And, although HHF’s returns had a higher correlation to the MSCI EAFE and S&P 500 indices (both in C$) of 0.44 and 0.62, respectively, there still is a meaningful diversification effect there as well.

HHF’s management fee of 0.95% is materially lower than those of most hedge funds. Lower fees typically translate into superior performance.

HHF’s annualized return of 8.9% has outstripped the returns of global hedge fund indices, such as the 7% return of the Credit Suisse hedge fund index and also compares very favourably with the 4.2% return of the Scotiabank Canadian hedge fund index, asset-weighted, over the same period.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.

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