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Alternative ETFs, Hedge Funds For the Little Guy

Companies / Exchange Traded Funds Feb 11, 2010 - 08:58 AM GMT

By: Ron_Rowland

Companies

Best Financial Markets Analysis ArticleWhether you’re investing in stock exchange traded funds (ETFs), bond ETFs, commodity ETFs, currency ETFs, international ETFs, or even inverse ETFs, you’re stuck with one big problem: Any way you look at it, you are making a one-sided bet on the future direction of a specific market segment.

Of course, if your timing is right, you can make a lot of money with these bets. If your timing is wrong, you stand to lose.


Well, here’s some good news: Now there are ETFs that don’t force you to bet long or short. Some take a blended approach that combines both bullish and bearish market positions, while others bypass the question entirely and try to make money in other ways.

With alternative strategy ETFs, you don't have to take sides.
With alternative strategy ETFs, you don’t have to take sides.

Today I’ll tell you about some of these special ETFs and why they might be just what the doctor ordered for these crazy markets …

Hedge Funds for The Little Guy

You’ve probably heard about hedge funds, those super-secretive private pools where millionaires stash their money. Yes, sometimes they blow up. But many hedge funds have a long history of good returns in all market conditions. They do this by combining sophisticated trading techniques with long and short positions in various markets.

The problem is that the best hedge funds aren’t available to everyday investors in small amounts. I can’t change that for you. But I can point you to some ETFs that try to use similar strategies.

“Alternative” is the name often used with this category of ETFs because they typically do not take a “traditional” approach to stock, bond, and commodity investing. And if you start looking into this category of ETFs, you’ll soon run into the cryptic-sounding term “130/30.” This refers to a portfolio tool that involves using leverage to combine a 130 percent long position with a 30 percent short position.

130/30 works like this: Say you have $1 million to invest. You borrow another $300,000 and invest $1.3 million in stocks you think will go up. At the same time, you enter a short sale of $300,000 in stocks you think will go down.

In this scenario your net position is 100 percent long — but if you pick the right stocks, your longs will go up and your shorts will go down. You’ll make money on both sides of the market. This is a simple variation of what many hedge funds do (with far greater leverage in some cases).

Two ETFs attempt to implement this sort of program for you — choosing the stocks to buy and short and giving it to you in one neat package:

  • ProShares Credit Suisse 130/30 (CSM)
  • First Trust Enhanced 130/30 (JFT)

So far their track record is mixed. But this category of ETFs hasn’t been around long enough to make a firm judgment yet.

Hedge Fund Replication: Beyond 130/30

Of course, 130/30 isn’t the only hedge fund-like ETF category. There’s another group of ETFs that uses a variety of strategies like long/short, global macro, merger arbitrage, and more. Some are even referred to as “hedge fund replication ETFs.”

Like the 130/30 ETFs mentioned earlier, most of these ETFs are too new to have developed a track record and trading is often spotty. These may catch on with investors over time, but for now I would suggest that you only window shop — it’s nice to see what’s out there, but maybe not a good idea to plunk down your hard-earned cash just yet.

Here are some ETFs to look at if you want to get a better understanding of this category:

  • iShares Diversified Alternative Trust (ALT)
  • IQ Hedge Macro Tracker (MCRO)
  • IQ Hedge Multi-Strategy Tracker (QAI)
  • IQ ARB Merger Arbitrage (MNA)
  • IQ CPI Inflation Hedged (CPI)

Earn Option Income with Buy/Write ETFs

You might be familiar with an investment technique known as “covered call writing.” Sounds fancy but it’s really quite simple. You just buy a stock and then sell an equivalent amount of call options against it. So what happens next?

Three possibilities:

First, if the stock goes up and stays there until your options expire, your shares will be “called” away from you at the prearranged strike price you picked. So in effect, you’ll be forced to sell at a profit. Maybe the stock will go up even more after you sell it. But no one ever went broke by grabbing a gain.

Second, the stock could go down, and you’ll keep it or sell it at a loss. But your loss will be reduced by the amount of the income you received from selling options that expire worthless.

Selling options can put extra cash in your pocket.
Selling options can put extra cash in your pocket.

Third, the stock could go sideways. Then you have neither profit nor loss on your shares, but you’ll get to keep the option-selling income. And you’ll still have your stock and can do the same thing all over again!

This strategy, also known as “Buy/Write,” is great for income-seeking investors who don’t want to desert the stock market completely. It’s also tailor-made for range-bound, choppy market conditions.

Here are some ETFs and ETNs (exchange traded notes) that apply the covered call technique to the S&P 500 and Nasdaq 100 Indexes:

  • PowerShares S&P 500 Buy/Write (PBP)
  • iPath CBOE S&P 500 Buy/Write ETN (BWV)
  • PowerShares Nasdaq 100 Buy/Write (PQBW)

Make Money from Market Volatility with VIX ETNs

When people say the market is “volatile” they usually mean “It’s going down!” However, volatility really means movement — in either direction. A volatile market is one that is likely to make a big move in the near future. Whether that move will be up or down is a different question.

Volatility means movement up or down.
Volatility means movement up or down.

Volatility is very important to futures and options traders. That’s why they developed ways to measure it, including the Volatility Index, or VIX. The VIX is a metric that expresses the amount people are willing to pay for call and put options on the S&P 500.

In practice, the VIX is a kind of “fear gauge” for the stock market. It tends to be low when investors are optimistic about stocks, and tends to surge higher when they are overwhelmed with fear. Extremes at either end can be a good, contrarian market timing indicator.

Barclays, under the iPath brand name, offers a pair of ETNs that attempt to track VIX futures for either the short-term or medium-term. Here are the names and tickers:

  • iPath S&P 500 VIX Short-Term Futures ETN (VXX)
  • iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)

Keep in mind that ETNs have some unique characteristics that make them riskier than ETFs in certain ways. Nonetheless, they can be very useful tools. Most important though is that these ETNs can go up when the stock market is falling. That’s a nice capability to have in today’s wacky market.

Best wishes,

Ron

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.


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