Exchange-traded funds aren't the best alternative

Yesterday in our story titled 'A silent spring for hedge funds', we talked about the hedge fund industry's job of providing uncorrelated returns and how it seems to have settled into underperforming a bull market and outperforming a bear market, instead of providing positive long and short returns at all times.

How about going to cash in bad times and into exchange-traded funds in good times, we mused. Whatever you might lose on the active management, the absence of two-and-twenty fees would help to compensate.

No! Says the hedge fund industry. Hedge fund consultants GFIA in Singapore say that portfolios containing hedge funds have better returns in all scenarios except in a strong bull market. The study they have sent us says: "Given that no investor has prior knowledge of market conditions over the medium- to long-term, using hedge funds to implement emerging market conviction is much more likely to generate attractive returns over the investment horizon."

In other words, why own an index the rest of the time? GFIA makes the point that if you can time markets, then trading exchange-traded funds and then switching to cash at the top is very profitable. However such consistent market timing skill is rare. 

"Forgive me for teaching grandma to suck eggs, but ETFs are a raging-bull-market strategy.  In the first third of a bull market, coming off the bottom, especially in inefficient markets like Asia, you want stockpickers, you want the mispricing-seekers," says Peter Douglas of GFIA. (Incidentally, Douglas was recently named one of AsianInvestor's 25 most influential people in asset management).

"Right now we'd argue it is well worth paying active fees to most of the more sensible managers. In the middle third of a market cycle, manager selection becomes much more important," adds Douglas. "For most professional investors, the need to mitigate return volatility, trumps maximising returns in the real world. We'd still argue that a hedged approach is more sensible for most allocators, but if you want market direction, now is NOT the time to use ETFs."