While investors can now benefit from an amazing array of exchange-traded fund (ETF) choices, some of them fail to live up to their billing. These funds often pursue complex, glamorous-sounding strategies that lure investors — but often woefully underperform.

Two funds in particular warrant closer scrutiny, due to their large popularity: PowerShares S&P 500 Low Volatility (NYSE: SPLV) and IQ Hedge Multi-Strategy Tracker ETF (NYSE: QAI) have problematic structures, and are delivering subpar returns.

#-ad_banner-#A Low Volatility Fund That Fluctuates More Than The Market
With net assets of about $5 billion, PowerShares S&P 500 Low Volatility is attracting its share of investors. The allure is in the name, which suggests broad exposure mainly to U.S. stocks with minimal volatility. But the fund provides neither of these virtues especially well.

Whereas the S&P 500 includes the 500 largest firms with Nasdaq or New York Stock Exchange listings, SPLV is actually based on a much smaller universe: the S&P 500 Low Volatility Index, which only consists of 100 stocks (the 20% of S&P 500 components with the least volatility over the past year). So the diversification of the fund isn’t nearly what the fund’s name implies.

Does the fund provide reduced volatility? Well, its beta of 0.79 suggests that it meets that part of its mission. (Beta compares an investment’s price behavior to that of the S&P 500, which always has a beta of 1.0 because it’s the benchmark.)

However, a three-year standard deviation of 9.0, versus 8.6 for the S&P 500, indicates that SPLV actually fluctuates slightly more than the market. (Standard deviation measures the variation of investment returns from the average.)

When evaluating a low-volatility investment, I like to see both of these metrics substantially reduced, preferably for at least the trailing ten years. SPLV was launched only about four years ago, so to my mind it’ll be quite a while until the question of whether it reduces volatility is definitively answered.

As for performance, it already appears that SPLV is built to lag. The fund’s 14% annualized rate of return over the past three years trails the S&P 500 by two percentage points, according to Morningstar.

This Fund Isn’t Keeping Up With The Gurus
Given the widely publicized exploits of Carl Icahn, Bill Ackman and other successful hedge fund gurus, it’s no surprise that investors are flocking to the IQ Hedge Multi-Strategy Tracker ETF — the first ETF to invest like a hedge fund. Since inception in 2009, net assets have soared to more than $1 billion, making QAI the largest ETF of its type, by a wide margin.

The construction of this fund’s portfolio is quite complex. It tries to be like a hedge fund by tracking the IQ Hedge Multi-Strategy Index, which incorporates six Dow Jones/Credit Suisse indexes representing different (but sometimes overlapping) hedge fund styles.

These include: long and short equity positions; market neutral, an approach that may involve long and short bets, among many other tactics; multi-asset global investing; focusing on emerging markets; event-driven investing (which uses earnings reports, mergers and other major events to spot stock price inefficiencies that can be exploited); and fixed-income arbitrage, which seeks to capitalize on price inefficiencies in bonds and other debt instruments.

QAI’s exotic bent hasn’t rewarded shareholders with Icahn or Ackman-like profits. Annualized total returns averaged only 2.9% over the past five years, barely keeping pace with the broader bond market, let alone the stock market.

Also, with two-thirds of assets currently in bonds, QAI carries substantial interest rate risk and could take a hit if the Federal Reserve starts hiking rates soon, as many analysts expect. While the fund is designed to rotate out of underperforming assets, the shift may come too late because the hedge fund data incorporated into QAI’s benchmark arrives with a one-month lag, cautions Morningstar analyst A.J. D’Asaro.

Risks To Consider: Closely examine any unconventional investment you’re considering to be sure it can deliver on any special promise, stated or implied.

Action To Take: If you hold SPLV or QAI, consider selling for the reasons described above. Since SPLV is arguably no less volatile than the S&P 500, consider replacing it with a regular index fund. The Vanguard S&P 500 ETF (NYSE: VOO) is an excellent choice because it precisely tracks the market and is dirt cheap to own, with an expense ratio of just 0.05%, versus 0.25% for SPLV.

Don’t bother seeking a replacement for QAI. Mutual funds and ETFs with hedge fund-like strategies aren’t apt to beat the market, and those that do won’t keep it up for long. Most will never come close.

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