ETF hedge funds: The Infinite Monkey Theorem

monkey traderThe infinite monkey theorem states that a monkey hitting keys at random on a typewriter keyboard for an infinite amount of time will eventually bang out some sort of recognizable text, such as the complete works of William Shakespeare.

Along the same lines, one might argue that Exchange-Traded Funds, or ETFs, are in alternatives’ form at least a version of the monkey-at-typewriter theorem, by virtue that a synthetic composition of securities combined into something that is purportedly a hedge fund can mimic, if not the best, but the same strategy and returns as a hedge fund manager — eventually.

All this monkey business theory stems from Rye Brook, New York-based IndexIQ’s release of the IQ ARB Merger Arbitrage ETF (ticker: MNA), which began trading this past Tuesday.

How it works: the ETF relies on a fixed rule book – the main requirement being that an acquirer must have offered a premium to a target company’s market price:


“To date, investors have not had broad access to capitalize on mergers and acquisitions activity in an ETF,” Adam Patti, IndexIQ’s CEO, said in a statement. “The Merger Arbitrage ETF is a hedged strategy designed to take advantage of price disparities that exist in merger activity and strengthen investor portfolios by buying below the target price and realizing the capital appreciation if the deal closes at or above the target price.”

In other words, rather than hiring experts at exorbitant prices to sift through deals and choose which to bet on, and paying a hefty fee in the process, one can buy an ETF of essentially the same thing, or so the theory goes.

So are ETFs about to replace hedge funds? Not exactly.

For starters, the M&A ETF hasn’t been around long enough to go through some unexpected turbulence – like when a deal collapses or when circumstances lead to a revaluing of a bid. This chart (below) is actually a pro-forma visual of the ETF, since it was only launched in the past week.

IQMNAT_01 Nov. 20

IndexIQ’s other hedge fund ETF, the Macro Tracker ETF, has weathered a bit more — four months to be exact — and isn’t hitting out of the ballpark.

What’s more, the ETF doesn’t have the same nimbleness of being able to slip in and out of positions that a hedge fund does; an ETF usually takes new positions just once a month, meaning it could miss the juiciest part of a trade.

On the flip side, ETFs are liquid and cheap, allowing investors to move money in and out as simply as transferring money into or out of a bank account, something no limited partnership hedge fund can lay claim to.

Of course, one could also argue that you get what you pay for. ETFs like IndexIQ’s rely on public data on hedge funds to build a portfolio of other ETFs that approximates a basket of hedge-fund strategies – a far cry from building a repertoire of deals through connections and know-how and then strategically betting on their intrinsic value and direction over time.

A monkey and a typewriter. With 1000 U.S. ETFs and counting, perhaps one day soon there will be a transparent nicely-packaged ETF that will replace real hedge funds.

The caveat: the strategies, whatever they may be, had better not be too complicated. Enough for a monkey to handle — eventually.

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One Comment

  1. Lurker
    November 24, 2009 at 9:54 am

    It would be interesting to compare the following:

    (1) results of a long/short arb strategy, over the last 10 years, on the 20 biggest annual acquisitions

    (2) same, but using the index futures or ETF as the short component (as the MNA fund does)

    (3) the actual results of actual merger arb hedge funds (is there an index for this?) over the same time frame Shocked

    Could be enlightening.

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