Hedge fund replication: the WSJ discusses its growing popularity

In a recent article in the WSJ entitled “Hedge-Fund Clones Draw Investors,” the obvious is highlighted: interest in hedge fund replication and “hedge fund clones” is increasing. The reasons are many-fold, and the WSJ points to the obvious benefit of avoiding high fees by holding “passive” hedge fund strategies instead of paying them with “active” strategies involving direct hedge fund investments.

I’ve discussed the idea of hedge fund replication previously and why I think it’s a good idea for the average individual investor at the present time. My previous post is here: https://knowledgecapitalist.wordpress.com/2009/12/14/strategies-for-uncertain-times-uncertainty-supports-hedge-fund-replication-strategies/

The URL for the WSJ story is: http://online.wsj.com/article/SB10001424052748704718204574615980132871774.html

They state: “Wall Street is trying to lure investors with investment vehicles designed to deliver hedge-fund-like returns without hedge-fund fees or hassles. But they have their own drawbacks.

These hedge-fund clones, called replicators, typically aim to mimic returns of broad hedge-fund indexes using easily traded instruments like exchange-traded funds and futures contracts. Some are structured as mutual funds or ETFs, others as separate accounts and other vehicles.

Investors, many weary of hedge funds’ high fees and long lock-up periods, are diving into replicators. Goldman Sachs Group, which launched a clone in 2007, now has roughly $2 billion tracking its replicator. State Street Corp. entered the replication business around the same time and now has more than $400 million in these products. Even start-up money manager IndexIQ has about $200 million in replication assets.

Investors are likely to hear more about clones in the coming months. Credit Suisse Group plans to launch two new clone indexes in the next few months, while Goldman Sachs is seeking to expand distribution of its Absolute Return Tracker replication fund through 401(k) plans. And early last month, State Street in a regulatory filing sought permission to launch a hedge replication ETF.

Some pension plans, like the Swedish government’s AP7 fund, are dumping funds that own hedge funds in favor of replicators. And even some funds of hedge funds are investing in the clones.

Cost considerations and high-profile hedge fund blow-ups drove the AP7 fund to invest in a clone last year, said Richard Grottheim, chief investment officer. Through a fund of funds, AP7 invested in Amaranth Advisors, which collapsed after bad natural-gas bets. In clones, “you don’t have that risk,” Mr. Grottheim said.

The firms offering replication products say they will deliver hedge-fund-style returns and diversification in a low-fee, transparent, easily traded package. Many charge fees of 1% to 2% of assets annually. Hedge funds, by comparison, often charge a 2% management fee, 20% of any gains and other expenses.

“We view what we’re doing as what Jack Bogle did at Vanguard in the 1970s” when he popularized index mutual funds, said Andrew Lo, a finance professor at the Massachusetts Institute of Technology and manager of Natixis ASG Global Alternatives, a replicator mutual fund.

Though the hedge-fund clones have a short track record, it’s not clear that they can deliver on their promises. Since they hold easily traded instruments like stocks, they often behave a lot like the traditional investments already held by most investors. Being limited to liquid investments, clones may also lag behind real hedge funds, which get some of their returns from holding hard-to-trade assets. And though most clones have so far kept pace with hedge-fund indexes, they have done so with more volatility, according to recent academic research.

Clones’ popularity is on the rise after a tumultuous year for hedge funds. The HFRI Fund Weighted Composite Index, a broad hedge benchmark, fell 18% last year, and investors yanked a record $155 billion from the funds, according to data provider Hedge Fund Research.

Here’s how clones work: They are typically designed to deliver hedge-fund “beta,” or the part of returns attributed to market exposure, and not “alpha,” returns attributed to manager skill. One common replication approach involves examining the past several years’ worth of hedge-fund index data and essentially reverse-engineering the returns, determining what market factors were driving the performance. The clone will invest in those easily traded instruments that best explain the returns, rebalancing the portfolio each month as it incorporates new data from hedge indexes.

While most clones have so far generally kept pace with broad hedge-fund indexes, their performance has been all over the map. Between March 2008 and Sept. 30 of this year, clones studied by researchers at Haute Ecole de Gestion in Geneva and Bank Julius Baer & Co. delivered annualized returns ranging from -21% to 6%. And some clones this year have sharply underperformed broad hedge indexes. State Street’s Premia Fund was up less than 2% in the first 10 months of this year, compared with a 10% gain for the HFRI Fund of Funds Composite Index.

The underperformance is due to the fund’s built-in risk controls and the fact that it couldn’t hold some less-liquid assets like distressed credit, said Bailey Bishop, vice president at State Street Global Advisors.

Being restricted to easily traded holdings, replicators may not capture a big chunk of hedge-fund performance. Anywhere from 10% to 60% of hedge-fund returns may come from a premium earned by holding illiquid assets, said Mr. Lo, the Natixis fund manager.

Some replicators behave a lot like stocks. Goldman Sachs Absolute Return Tracker mutual fund, for example, had a roughly 80% weekly correlation with the Standard & Poor’s 500-stock index from its launch in May of last year through Oct. 31, according to Morningstar.

“The correlation to any single index like the S&P 500 is going to move around quite a bit” over time, said Glen Casey, managing director at Goldman Sachs Asset Management.”

Hedge fund replication ETFs

A natural extension of the ongoing ETF creation boom, we’re starting to see full-blown “hedge fund” ETFs. After examining the funds (strategy, holdings and expenses) I come away unimpressed. I’m referring to IndexIQ’s two “hedge fund” ETFs: QAI and MCRO. They are not expensive, with total expense ratios around 1.0%, but the logic as to what they hold and why is less than obvious, nor do they appear to be in any way positioned to outperform for any smart/unusual/unique/non-consensus reason.

Here’s IndexIQ’s website: http://www.indexiq.com/etfs/etfsiqh.html

Their HF ETFs at the moment:

1) IQ Hedge Multi-Strategy Tracker ETF (Ticker QAI)

2) Q Hedge Macro Tracker ETF (Ticker MCRO)

The “multi-strat” ETF prospectus says that the ETF will try to match the underlying returns of the IQ Hedge Multi-
Strategy Index. They elaborate a bit more:

“The Index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage, and emerging markets.”

So basically what you get is a hodge-podge of various hedge fund strategies, although the allocations and composition of the exact holdings is essentially unknown. I’m not a big fan of low-transparency (not that they’re trying to hide anything, you just don’t really know what they hold and what they’re changing and why). The majority of those pieces can be replicated by just separately buying funds that focus on each specific piece. For example, you can buy the emerging market ETF EEM, any number of “event driven” or “special situations” or “merger arbitrage” funds like the other ones I’ve discussed in previous posts, and you can take your pick of long/short equity funds based on YOUR evaluation of the manager and their track record (QAI doesn’t really have a track record at this point b/c it’s young and simulated returns are dangerous to rely on in the vast majority of situations as the past rarely repeats itself). Furthermore, as of their last holdings disclosure, the fund held 42% of assets in long positions in short-term treasuries (like you need them to earn a treasury yield) and 24% of assets were long the EEM ETF exactly with about 10% of assets in the Powershares G10 currency ETF. So…they’re not doing anything you can’t do for yourself (and if you do it yourself you can control things, which may or may not be what you’re looking for).

The macro fund tracks the performance of the IQ Hedge Macro Index. Looking at their top 10 holdings, the macro fund’s portfolio is slightly-more complicated than the QAI portfolio, but pretty straight forward anyway.  28% of the fund’s holdings are just EEM. There’s a tiny short treasuries position, but it’s dwarfed by the long treasuries positions. The “ultra short” real estate position is one of the few distinguishing positions (tho it’s only 3.7% of fund assets) b/c it’s both short and levered, so presumably they have reasonable conviction that there is further downside in real estate. I don’t see anything here that impresses me or suggests to me that this fund does anything beyond simplify the construction and purchase of a portfolio of emerging market stocks, various treasury and corporate bonds (both US and international), currency ETF holdings, and a small position betting against the real estate sector. All in, MCRO doesn’t do it for me, but I’m not you, and maybe you like the idea of one purchase that requires no follow-up maintenance.

TickerName Weight
EEMiShares MSCI Emerging Markets Index Fund 28.43%
SHYiShares Barclays 1-3 Year Treasury Bond Fund 15.90%
LQDiBoxx $ Investment Grade Corporate Bond Fund 13.29%
BWXSPDR Barclays Capital International Treasury Bond ETF5.63%
BSVVanguard Short-Term Bond ETF 5.23%
SHViShares Barclays Short Treasury Bond Fund 3.97%
SRSProShares UltraShort Real Estate 3.69%
DBVPowerShares DB G10 Currency Harvest Fund 3.35%
TWMProShares UltraShort Russell2000 3.29%
BILSPDR Barclays Capital 1-3 Month T-Bill ETF 1.99%

Strategies For Uncertain Times: Short / Bear Funds

Short/Bear funds

Overview: Provides upside should equities decline, however, will be a drag on returns over long-term b/c long-term trend for equities is consistently positive. Only makes sense if you have large long-equity holdings and you want to reduce your overall portfolio volatility or are very cautious about equities in general. There are a TON of ETFs that are “short” various indexes with leverage, and try to generate 2x or 3x the decline in their underlying securities. However, for several reasons that are probably a bit too complex for the vast majority of investors, these ETFs do not accurately reflect changes in the underlying securities the way that they are assumed to on a short-to-medium term basis. Hold in a taxable account so that if the market declines your short/bear position gains will be covered by bigger losses in long-equities positions.

• Open-end mutual funds:
  • BEARX: Federated Prudent Bear
    • Not always net short
    • Underperf GRZZX in 2008, better performance all other years, even up mkts
    • 5% load, 1.8% annual fee
  • GRZZX: Grizzly Short Fund
    • Quant based
    • US only
    • Better 2008 than BEARX, much more volatile LT returns
    • No load but 3% annual fee
• ETFs: (you can clearly short the index ETFs as opposed to being long these inverse-index ETFs)
  • SH: S&P short
  • PSQ: Nasdaq short
  • RWM: Russell 2000 short
  • SBB: S&P Small-Cap 600 Short
  • EUM: Emerging market equities (MSCI) short
  • EFZ: Emerging market equities (MSCI) short

Strategies For Uncertain Times: Long/Short Equity

L/S Equity or Market Neutral Equity

Overview: Funds are either long/short with some long exposure (not entirely hedged against market movements) or are market neutral (which TRY to be entirely hedged against market movements). This strategy has roughly a 0.60 beta vs. S&P over the last 10 years. Long/short funds either pick their positions based on fundamental analysis or employ quantitative screens for identifying investments. Additionally, not all funds short single stocks against their long positions, and might short various equity indexes or short futures to hedge against market declines. If you’re gonna be long equities at an uncertain time in the macro cycle or at uncertain overall market valuations it makes sense to be long/short as opposed to long-only. Hold in either a taxable or tax advantaged account.

• Open-end mutual funds:
  • HSGFX: Hussman Strategic Growth
    • Long single stocks, short index and buy puts
    • Almost entirely hedged exposure
    • Down 9.6% in 2008, good
    • 1% expense fee
    • No load
    • Low turnover
    • Down 10% in 2008
    • 8% std dev
  • DRCVX: Comstock Capital Value
    • Up to 50% short, solid returns
    • Global
    • UP 50% IN 2008
    • Lose money frequently, negative 5 year annualized return, down 2009 YTD
    • 22% std deviation
    • 5.75% load and 1.7% annual fee
  • COAGX: Caldwell + Orkin Market Opportunity
    • Totally unrestricted hedge fund, great manager, Michael Orkin
    • $25k minimum
  • CVSIX: Calamos Market Neutral A
    • Convert arbitrage and covered call strategies only (roughly 50/50)
    • 1.1% annual expense with 4.75% load
    • 7.7% std dev on 3 year basis
    • 5 year annualized return of 2.2%
    • 110 positions with high turnover
    • MOSTLY covered calls
    • Down 13% in 2008
  • OLA: Old Mutual Claymore Long-Short
    • Long/short equity with covered calls for ~85% of portfolio
    • 130/30, so roughly 20% short with no more than 100% long
    • Specific stock longs and shorts based on quant model
    • Stocks are mostly large cap
    • Beta of 1.07 w/ S&P
    • Down 40% in 2008, very poor performance for a “hedged” strategy
    • 18% std dev
    • 2.7% annual fee
  • BPLEX: Robeco Boston Partners Long/Short
    • No load, 2.75% annual fee
    • Fundamental analysis
    • Down 21% 2008, too much for a “hedged” strategy
    • 13% 5 year annualized return
    • 22% std dev
    • 5 star Morningstar
    • Very diversified, individual stock shorts (20% short)
  • Other poor L/S equity fund choices
    • (HSKSX: Highbridge Statisical Market Neutral: not fundamental, $1m min investment), (ALPHX: Fee too high), (MADEX: Not consistent in returns), (DIAMX: Too volatile), (MLSAX: Closed), (TFSMX: Closed), (AARFX: Too young), (FMLSX: Too volatile), (JAMNX: Weak returns), (TMNVX: The Market Neutral Fund: Just switched advisors), (NARFX: Too new/young, not enough track record)
• CEFs:
  • DHG: Dreman Value:
    • Volatile returns, does have specific stock shorts
    • Has beta of roughly 1.25 w/ S&P (very high)
• ETFs:
  • ALT: iShares Diversified Alternatives ETF. Full range HF multi-strat ETF
    • Objective:Yield/futures arb, technical trades, fundamental relative value
    • Current holdings are mostly currency, IR, and index futures
    • Just started
  • QAI: IQ Hedge Multi-Strategy Tracker ETF
    • Just started

Strategies For Uncertain Times: Merger Arbitrage (and Special Situations)

Overview: Merger arbitrage involves long/short equity positions in an attempt to exploit M&A takeover mispricings. In some ways the merger arbitrate strategy can’t be divorced from general “special situations” strategies like spin-offs and corporate reorganizations.

Merger Arbitrage/Special Situations

Overview: Low correlation with S&P. Current historically high levels of corporate balance sheet cash balances combined with unfreezing of credit markets should lead to more M&A activity and benefit merger arb strategies. Merger arb strategies throw off lots of cap gains b/c of high turnover on deals so it’s best to hold it in a tax advantaged account.

• Open-end mutual funds:
  • ARBFX: Arbitrage Fund
    • ¼ the size of MERFX, might mean they can get out of blown deals easier
    • Mgmt focuses on strategic deals, not LBOs, and is focused on vol-adjusted returns
    • 1.9% annual expense
    • 5.28% std dev on 3 year basis, has roughly 0.40 beta w/ S&P
    • 5 year annualized return of 4.7%
    • 65 positions with high turnover
    • Down 1% in 2008
  • MERFX: The Merger Fund
    • 1.5% annual expense
    • 4.96% std dev on 3 year basis
    • 5 year annualized return of 4.4%
    • 42 positions with high turnover
    • Down 2% in 2008
  • GABCX: Gabelli ABC Fund
    • 0.64% annual fee, no load
    • 4.6% std dev on 3 year basis, beta of 0.20 vs. S&P
    • 5 year annualized return of 5.3%
    • 140 positions with high turnover, very diversified, currently 100% long
    • Merger arb, special sits, value oriented common stocks, convertible bonds
    • Down 2.6% in 2008
    • Morningstar 5 star fund
    • Almost entirely US although is global in focus
• CEFs:
  • GDL: Gabelli Global Deal Fund    
    • VERY diversified
    • All special situations: merger arbitrage, spins, reorgs
    • Global, but almost all US at the moment
    • Existing holders are buying at the moment
    • 90 positions with high turnover
    • Low annual fees of only 0.66%
    • Only 3 year history, but has a 0.65 beta w/ S&P
    • Down 8% in 2008
• ETFs:
  • MNA: IQ ARB Merger Arbitrage ETF
    • Does NOT actually short shares of the acquirer, only indexes, so it’s not real arbitrage
    • Just started
    • 0.75% annual fee

Strategies for Uncertain Times: Commodities

Overview: I’m talking about the actual commodity futures, not equities of companies involved with commodities, and also preferably on a long/short basis. Commodities have a negative 0.04% correlation with equities over the last 10 years. Commodities CAN be an uncorrelated play on basic raw materials & energy, which may move independently of equities although they are macro cycle dependent. Commodities are positively correlated with inflation, which will increase. I prefer long/short commodity strategies to long-only b/c the risk of draw-down is less when commodities are not in a strong uptrend. Low distributions from actual-commodity funds (as opposed to equity-focused funds) means it’s probably best to hold in a taxable account if you plan on holding for longer than one year. Remember, equities of natural resources companies have a VERY high beta versus the S&P over the last 10 years, so you don’t get the diversification benefit as well as if you hold actual commodity futures.

• Open-end mutual funds:
  • PCRDX/PCRAX: Pimco commodity real return fund
    • Invests partially in another Pimco actual commodity fund
    • 29% std dev and a 0.80 beta vs. S&P
  • HACMX: SAME as PCRDX but with lower fees, same mgmt team
  • CRSAX: Credit Suisse Commodity Return Strategy (long-only)
    • 0.90% annual fee
    • 23% std dev and 0.58 beta vs. S&P
  • RYLBX/RYLFX: Rydex Long/Short Commodities Strategy
    • Based on 12 month price trend following model
    • 4.75% load, 2% annual fee (estimated fees, it’s brand new, but still too high)
    • Can be long or short any commodity, can be net short depending on model outcomes
• ETFs:
  • GRES: Global resources, hedged. All commodity sectors but only through equity positions. Short the index against long equity positions. Does not hold actual commodities.
  • LSC: ELEMENTS S&P Commodity ETN
    • Long/short actual commodity futures ETN based on price trend following.
    • Direction of long/short based on 7 month exponential moving avg
    • 6 sectors, 16 actual commodities. Fixed weight to sectors, always long energy
    • Rebalanced monthly
    • Only 0.75% annual fee
  • RJI: Broadest long-only actual commodity ETF, followed by DJP and then GSG
  • IGE: North American Natural Resources
    • Only holds equities of natural resources companies
  • HAP: Hard Asset Producers
    • Only holds equities of hard asset companies, 60% international

Other Notes:

• Equity-based natural resource funds have VERY high beta vs. S&P, so DON’T buy them
• L/S commodity funds have a NEGATIVE beta vs. S&P
• Agribusiness is popular subset of this (like Potash fertilizer, etc).
  • MOO is the active agribusiness ETF
  • PAGG: PowerShares Global Agriculture ETF

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.