Hedge funds and ETFs make an odd couple. Their reputations stand in stark contrast:Hedge funds are secretive, elitist and expensive, while ETFs are transparent, egalitarian and cheap.
So, how can these two disparate vehicles possibly go together?
In fact, more than two dozen ETFs aim to deliver hedge-fundlike returns in some fashion. ETFs often emulate specific hedge fund strategies, like merger arbitrage, managed futures and currency-carry trade, to name a few.
To be clear, no ETFs take direct positions in hedge funds themselves. Instead, ETFs use other means.
Some take a direct approach and get long and short exposure to similar types of securities that a hedge fund might. Others apply complicated math to hedge fund indexes to map out allocations onto broad baskets of stocks, bonds and other liquid asset classes.
But a third group uses a dirt-simple approach. These are the so-called copycat funds that free-ride off hedge funds’ actual holdings listed in regulatory disclosures.
This approach has no shortage of detractors in the liquid alternatives community. Pundits cite a lack of sophistication as well as a glaring timing problem:Holdings are published 45 days after each quarter, while hedge funds themselves might take fleeting positions, like a few days or even hours at most.
The copycats counter the stale-data objection by searching for positions that hedge funds hold for longer periods of time—sticky assets, in other words. Also, proponents of copycat ETFs push back on the lack-of-sophistication argument by citing the use of manager-performance screens and the ability to toggle to defensive positions in volatile markets.
Are Copycats Top Dogs?
Copycat funds have a new way to bolster their cause:best-in-class returns. IndexUniverse lists 25 ETFs that follow hedge fund strategies or aim for absolute returns and have at least one year of performance.
The 2 copycat funds rank first and second for one-year returns as of Aug. 2, 2013. These are the Global X Top Guru Holdings ETF (GURU), with a scorching 53.4 percent return; and the AlphaClone Alternative Alpha ETF (ALFA), with gains of 31.5 percent. For reference, the SPDR S'P 500 (SPY) returned a solid 27.9 percent for the period.
Interestingly, few hedge fund ETFs come anywhere close to these returns. In fairness, most don’t even try.
Many hedge fund ETFs aim for quieter spots on the risk/return continuum, rather than aiming for shoot-the-lights-out returns.
In fact, IndexUniverse’s own analytics methodology for this space rewards low volatility and low correlations with other asset classes—two areas where both GURU and ALFA fall down hard.
Indeed, the performance profile of GURU and ALFA highlights their role in a portfolio. At heart, these funds are long-equity stock pickers, not all-weather diversifiers.
Still, all qualifications aside, the real-world performance of GURU and ALFA bolsters the copycat proof of concept. Defending 53 percent returns is a position many investors and issuers would love to be in.
Along with the tenuous relationship between past performance and future results, investors interested in GURU and ALFA have other considerations.
For example, both have short performance histories—just over a year. Both come from smaller issuers rather than giant fund companies such as Vanguard, BlackRock or State Street.
Also, fees in this corner of the ETF world aren’t cheap.
GURU and ALFA charge 75 and 95 basis points, respectively, or $75 and $95 for each $10,000 invested, which is on par with peer funds, but hardly like SPY’s 0.0945 percent.
Trading costs ratchet expense up a notch too. Bid/ask spreads average in the 20-30 bps range for the funds, which isn’t prohibitive, but still calls for careful trading.
For one-year niche funds, asset levels are strong for GURU, more than $100 million, but not so much for ALFA, which still stands under $20 million in assets.
In fact, the two drivers of asset growth for GURU—net inflows via creations and strong returns—likely caused the fund’s sizable capital gains distribution in late December, as the portfolio managers had no way to wash out the gains on underlying securities.
Still, I’d guess many fund issuers and investors alike would be happy to forgo some ETF tax efficiency in the context of torrid growth.
Whether the copycats have one life or nine remains to be seen. While GURU crushed its peers and the S'P 500 over the past 12 months, ALFA merely edged the latter. And free-riders that get on board too late face real risks, as noted in recent Bloomberg piece .
The performance history of hedge fund ETFs is both brief and varied.
I don’t see any method to date—direct security exposure, hedge fund replication or copycat—that can claim consistent advantage. But recent performance at least gives the copycats a seat at the table.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at email@example.com.
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