5 Questions On Hedge Fund Replication ETFs
Andrew Beer
Dynamic Beta Investments
Replicating the investment and performance of some of the biggest hedge funds is a popular idea, but one that’s often plagued by complexity.
Andrew Beer, managing member of Dynamic Beta Investments, has been on a mission to demystify this segment and make hedge fund replication simple, accessible and affordable to investors everywhere. To that end, he’s found that the ETF wrapper is a great tool to achieve that.
Beer is subadvisor to a pair of liquid alts ETFs launched in late 2019 by iM Global Partners—the iM DBi Managed Futures Strategy ETF (DBMF), a quantitative actively managed strategy that replicates the investment and performance of a group of hedge funds; and the iM DBi Hedge Strategy ETF (DBEH), which replicates long/short equity hedge fund strategies through futures contracts.
We caught up with Beer to talk about the challenges and opportunities, and why you should care about hedge fund replication strategies.
ETF.com: What is it about liquid alts that appeals to you as a segment?
Andrew Beer: I started in the hedge fund industry in 1994 working for legendary value investor Seth Klarman. After that, I started several “real” hedge funds—illiquid, expensive, only open to qualified investors. During this time, I watched the hedge fund business change completely—not just how hedge funds invest, but who invests in them and how people even talk about things like “alpha.”
Then, around 2007, I became singularly fascinated by a question I kept hearing from institutional allocators: Can you find a way to outperform leading hedge funds with low fees and daily liquidity? I accepted the challenge and basically fell into the “liquid alts” business—really before anyone used the term.
Today liquid alts as a segment is endlessly fascinating to me because it seems so ripe for improvement. There’s widespread disappointment and frustration among both advisors and clients. I’m hell-bent on trying to make it better.
ETF.com: What do you think are the main issues with the space? Why is it hard to access this space successfully, and how can ETFs help?
Beer: We believe most investors are frustrated with liquid alts for three reasons: performance overall has been poor; star managers blow up with alarming frequency; and fees often are high. Plus, the space (including mutual funds) can be mind-numbingly complicated, with hundreds of products, most of which have confusing bells and whistles.
About five years ago, we first wrote about a less obvious issue: The vast majority of liquid alts products are too risky for retail portfolios for the simple reason that there is too much “single manager risk.” In hedge-fundlike strategies, yesterday’s shining star might underperform its benchmark by 20% this year. That risk is a serious problem for retail portfolios because advisors typically pick one fund per strategy bucket.
To put the risk in context, making a 5% allocation to a single-manager liquid alts fund is like deciding to put 5% in small caps and picking two or three stocks—clearly, no prudent advisor would do this. Yet in liquid alts, it’s been quite common. Fortunately, allocators seem to appreciate this far more today, especially after some high-profile blowups in the first quarter.
ETFs that can solve these three issues—performance, single-manager risk and fees—potentially can provide valuable diversification for thousands of portfolios, and improve the advisor and client experience.
ETF.com: You subadvise two liquid alt ETFs in the managed futures and long/short categories. How is your approach to hedge fund replication unique?
Beer: Our approach is very simple: We identify 20-40 leading hedge funds, figure out how they’re invested right now, and replicate their core exposures with highly liquid instruments. Our first goal is to provide “indexlike” exposure to either managed futures or equity long/short by diversifying single-manager risk. This cuts risk by half to two-thirds relative to investing in a single-manager product.
Our second objective is to deliver alpha. Whereas most replication products seek to match hedge fund performance, we pioneered the concept of delivering alpha by cutting out fees and expenses. Basically, hedge funds generate a lot of alpha, but too much is paid away in high fees. So, we seek to address this by replicating most or all pre-fee hedge fund returns. We have an expression for this: Fee reduction can be the purest form of alpha.
ETF.com: There's a lot of complexity in this space. How should an investor evaluate risks in liquid alt ETFs?
Beer: First, the fund manager should be able to explain simply and clearly what they are doing, and why and how it can benefit an advisor’s portfolio. If he or she can’t, walk away. It’s our job to educate and explain the value proposition.
Second, there are a lot of single-manager products masquerading as “indexlike” solutions. For instance, in the first quarter, a suite of bank-sponsored products pitched as indexlike replication underperformed by up to 20%—that downside deviation should never happen with an “indexlike” product. There’s no simple way to determine this: Just keep asking tough questions.
Finally, “passive” does not mean lower risk: Some products are built to track the index sponsors can license, not what investors actually want. It’s a bit like seeking exposure to the S&P 500 but instead picking a product that tracks a small cap index.
There’s no easy solution, but we think it’s helpful to talk to someone with experience evaluating actual hedge funds. Those of us in the business can recognize the landmines. Like any other area, experience and judgment matter a lot here.
ETF.com: Are there misconceptions about the opportunity and the implementation of liquid alts ETFs in a portfolio? Any tips you can share?
Beer: Today most RIAs and wealth management platforms incorporate some form of liquid alts—albeit mostly in mutual funds. In 10 years, we believe every robo advisor and ETF-based target date fund will have long-term strategic allocations to hedge-fundlike strategies.
Two obstacles are product design and education. Model portfolios are built on the concept that asset allocation will drive returns over the next 10 or 20 years—the time horizon is very, very long. For that, products should seek to deliver stable “strategy” or “asset class” returns.
[Just] as important is education. Allocating to any hedge-fundlike strategy is difficult, and allocators face not only constraints on how they can invest, but on well-known behavioral biases that lead to things like returns-chasing. We hope to play a role in working with allocators of different stripes to share our experiences from the hedge fund world.
Contact Cinthia Murphy at cmurphy@etf.com
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