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New ETF Mimics Top Hedge Funds

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It would be easy to dismiss the new AlphaClone Alternative Alpha exchange-traded fund as just a gimmick, but the numbers supporting this ETF’s concept are compelling.

The basic idea is to populate the fund based on the 13F filings of the most consistently successful hedge fund managers.

AlphaClone has a database that goes back to 2000, which analyzes and scores more than 300 hedge funds.

Most of this process is proprietary, but what we do know is that AlphaClone will make stock picks based on the filings from the hedge funds that consistently outperform the S&P 500 index.

It won’t disclose the number of hedge funds it currently tracks, but when I asked AlphaClone CEO Maz Jadallah if it would be more than half a dozen he said “yes,” which gives credibility to AlphaClone’s assertion that it’s ETFis a virtual fund of funds.

AlphaClone currently has 83 stocks in it plus a small cash balance. Each pick is given an equal weighting from each hedge fund tracked, but if multiple managers own the same stock then that stock can have a relatively large weighting.

For example, Apple is by far the largest holding at roughly 7 percent because it was reported on multiple 13F tracked by the fund. Most of the holdings in the fund appear to have a 1 percent target weighting.

AlphaClone also has a defensive component to it. If at the end of a calendar month the S&P 500 closes at less than its 200-day moving average, the fund will shift from 100 percent long to 50 percent long and 50 percent short .

The short exposure will be captured via an unleveraged inverse S&P 500 fund such as the ProShares Short S&P 500.

The objective here is to avoid the full consequence of large market declines, but holders of the fund should be prepared to endure small market declines when they occur. This is probably good advice for any equity market investor.

The obvious question about this fund is the 45-day lag in reporting information in 13Fs. Hedge funds have up to 45 days from the end of each quarter to report their holdings. Depending on the hedge fund, the holdings could be long gone by the time the filings are made public.

But as mentioned above, the data are compelling. AlphaClone reports an average annualized return of 17 percent for its strategy when backtested from Jan. 1, 2000 through year-end 2011. That compared to slightly better-than-break-even for the S&P 500 (that comparison does include S&P 500 dividends).

AlphaClone believes that an important contributing factor to the published results is that the cloning strategy does not have to overcome the typical 2-and-20 pay structure — 2 percent of assets and 20 percent of profits — that so many hedge funds impose.

To buy this fund would require a belief that the past results can be repeated under the hood of a new ETF, but one thing is clear: This is not the gimmick that it appears to be at first blush.

—By Roger Nusbaum, Contributor, TheStreet.com

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Disclosures:

TheStreet’s editorial policy prohibits staff editors, reporters, and analysts from holding positions in any individual stocks. At the time of publication, Nusbaum had no positions in securities mentioned.

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