Hedge funds get a bad rap. Their sky-high fees are a major turn-off, especially when you consider how often hedge funds underperform the broader-market indices.
However, that bad rap might be unjustified.
That’s because most investors think hedge funds equal outlandish returns. But that’s not true. The real purpose of hedge funds is to provide competitive returns with less risk than the overall market, and on that count, they can make for a good investment.
Which is why I was giddy when I found out that State Street (STT) unveiled what’s essentially a hedge cloaked in a cheap ETF.
For retail investors, the new actively managed SPDR SSgA Risk Aware ETF (RORO) could be one of the best portfolio diversifiers out there.
A Hedge Fund in an Exchange-Traded Fund
That’s fine, except they aren’t hedge funds themselves. When you look at their underlying holdings, there’s no risk control.
The new RORO ETF is different — it actually provides attention to risk while giving investors upside in rising markets.
The actively managed RORO does this by using a computer-driven model, similar to many algorithm-driven hedge funds. RORO will check factors like beta (which looks at the power of the market environment) and size (which measures the commitment of investors behind a bullish/bearish trend). The ETF also will look at “risk” items like credit spreads, rising/falling gold prices, U.S. dollar exchange rates and implied volatility during its evaluation process.
By checking these various factors, RORO will determine whether the market is a “risk on” or “risk off” environment and position the portfolio accordingly. The ETF will categorize the market into three groups based on its determined risk appetite — high, moderate and low. Based on this weighting, RORO’s algorithm will then adjust its portfolio’s exposure to large-, mid- and small-cap stocks, which it pulls from the broad Russell 3000 index.
In low-risk environments, RORO will be more heavily weighted toward small- and mid-caps, while high-risk environments will see more large-cap stocks in its mix. In periods of moderate risk, the ETFs composition will more closely reflect the broader Russell 3000 and have a much greater exposure to mid-cap companies. Current top holdings of RORO include several stocks on the low end of the large-cap scale, such as real estate investment trust General Growth Properties (GGP), Lincoln National (LNC) and TRW Automotive (TRW), implying we’re in a period of medium if not slightly high risk.
The basic idea for the ETF is to outperform the broad-based Russell 3000 in any market. The ability to shift market caps will provide the extra “oomph” or alpha to do so. Market’s going gangbusters? The extra weighting toward small-caps will lead to higher returns. The market is starting to panic? Stoic large-caps with their hefty dividends will cure what ails ya.
This attention to risk makes RORO a true hedge fund-esque ETF, and could be a great risk control tool for investors.
Of course, given that this is a hedge fund ETF, we have to talk about expenses.
Hedge funds typically use a “2 and 2o” expense structure, in which managers get 2% to run the fund, but also 20% of the profits it generates. That’s expensive. Many hedge fund replication ETFs charge around 1% for their services, which is an awesome deal in comparison.
Well, RORO goes one-step further and allows investors to gain hedge fund-like exposure for just 0.5% or $50 per $10,000 invested. That actually makes the ETF cheaper than some sector funds — without any risk controls.
RORO Is an ETF Buy
If RORO lives up to its hype and delivers better returns in any market environment while reducing risk, it could be a great satellite position for retail investors. Using it alongside broad index funds and ETFs could help reduce a portfolio’s volatility, reduce risk and (most importantly) reduce drawdowns during the market’s various hiccups.
For someone near or in retirement, that could be a godsend. After all, these investors don’t have the time to really make up for any major recession or bear market.
Add in the very un-hedgie-like expense ratio, and RORO has a recipe for success.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.