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Attack of the Hedge Fund Clones

If trying to mimic every hedge fund is a mistake, what about picking some of the top managers and copying them? Photograph by Peter Cade/Getty Images Close

If trying to mimic every hedge fund is a mistake, what about picking some of the top... Read More

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If trying to mimic every hedge fund is a mistake, what about picking some of the top managers and copying them? Photograph by Peter Cade/Getty Images

In the investment world there are two kinds of people -- those who want to beat the market, and those who want to be the market. Hedge fund managers are the former, while index fund managers are the latter. But what happens when an indexer wants to track the hedge fund market? You end up with funds bearing wonky, impenetrable-sounding names like the AdvisorShares QAM Equity Hedge (QEH) and AlphaClone Alternative Alpha (ALFA).

If you can make it past the jargony horror of the fund names and their strategies, they're a pretty interesting bunch. The AdvisorShares QAM ETF, started last August, uses what’s known as a (you were warned) “beta replication” strategy to mimic the HFRI Equity Hedge Total Index of 1,000 hedge funds. “Attempts” is the key word because unlike a Standard & Poor’s 500-stock index fund, which can buy each stock in its benchmark, ETFs aren’t legally allowed to invest in illiquid hedge funds.

What’s more, even if ETFs could do that, many of the best hedge funds in the index are closed to new investors. So co-managers Kurt Voldeng and Akos Beleznay analyze the returns of the index and the individual funds in it, and attempt to simulate those returns using ETFs.

While Voldeng and Beleznay can’t track a hedge fund's exact stock picks in real time, they can capture the returns of the broad asset classes it invests in. That's because each sector and asset class -- emerging-market stocks, for instance -- have distinct performance characteristics that are identifiable and easily imitated.

To get a feel for how this works, imagine that on a day when most global stock markets are flat, Mexico announces better-than-expected growth in gross domestic product and the iShares MSCI Mexico ETF (EWW) rises 3 percent. If a hedge fund is also up 3 percent that day, it's likely that it, too, has exposure to Mexico, and that by investing in the Mexico ETF you can capture the broad essence of that exposure.

Voldeng and Beleznay don't just analyze performance numbers. The HFRI index is broken down into specific subcategories of hedge funds, such as long/short technology, which enables them to get a sense of where the funds are normally invested. “We also use our own experience in knowing how these long/short equity managers behave in various market environments,” Voldeng says.

To Mimic, or Not to Mimic

Is trying to create a hedge fund index worth it? On the surface, the answer appears to be yes. From 1990 through 2012, the HFRI index produced a 13.7 percent annualized return, besting the S&P 500’s 10.2 percent return and doing so with less downside volatility.

Yet, as all investors know, past performance is no guarantee of future results. Because there are so many hedge funds -- they hold more than $1 trillion in assets -- it's become harder for them as a group to differentiate themselves from more conventional investment products.

“Hedge funds in aggregate are going to look more and more like the broader market as their asset base continues to grow,” says Carl Friedrich, a financial planner at Piermont Wealth Management in Woodbury, New York. “You get an S&P 500-like index effect.”

If trying to mimic every hedge fund is a mistake, what about picking some of the top managers and copying them? Enter the AlphaClone Alternative Alpha ETF. “We’ve built a data set of arguably the best money managers in the world,” says Maz Jadallah, who designed the AlphaClone index that the ETF tracks.

Best of the Best

Jadallah analyzes the holdings of more than 400 top-performing hedge fund managers via their quarterly 13F filings with the Securities and Exchange Commission. He then selects 75 of their favorite stocks for the ETF. Another fund with a similar 13F-based strategy, the Global X Top Guru Holdings Index (GURU), also launched last year.

Such strategies face a host of obstacles. Securities law allows hedge fund managers to file 13F holdings reports 45 days after the quarter ends. Many wait until the last minute to reveal their portfolios. So most of that information is at least 45 days old, and information on stock buys could be as much as 135 days old if they were bought at the start of the quarter.

To counteract this, Jadallah scores each manager’s portfolio based on the persistence of their performance after their holdings are disclosed -- that is, how well their stock holdings continue to perform long after the 13Fs are filed. He has 13F data for managers dating back to 2000, and only the holdings of those funds with top persistence ratings go in the ETF.

A potentially bigger problem is that 13F filings don't disclose what hedge funds are shorting or betting against. “You’ve kind of taken the hedge out of the hedge fund strategy if you don’t know what these funds are shorting,” says Friedrich. “You’ve got less than half the puzzle.”

Short Strategy

Jadallah can short in the ETF but uses a facile system. If the S&P 500 crosses below its 200-day moving average, he establishes a 50 percent short position in that index. If it’s above, his portfolio is unhedged. Jadallah argues that mimicking hedge fund short positions precisely isn’t very relevant. “In our research we’ve found very little alpha [excess return above a benchmark] in hedge funds on the short side,” he says.

So far he appears to be right. Although the AlphaClone ETF is relatively new, in separate accounts Jadallah runs in a similar style he says the strategy has delivered a 28.5 percent cumulative total return since its January 2011 inception through April 2013. (That return is based on “unaudited estimates generated by AlphaClone,” to use the fund's terminology.) That's well above the HFRI’s 4 percent.

Of course, the market was mostly rising during that period, so the AlphaClone strategy would be largely unhedged. If you had bought a S&P 500 index fund during the same period, you would have gained 33.5 percent.

Although cheap compared with a hedge fund, the AlphaClone ETF's 0.95 percent expense ratio is 19 times that of the Vanguard S&P 500 ETF. The AdvisorShares QAM ETF’s fee is 1.64 percent. The price alone may turn off penny-pinching ETF investors.

More detrimental to sales could be the complexity and lack of transparency of these funds. Jadallah refuses to disclose which top-performing hedge funds he seeks to track, to protect his fund from being “front run” or copied by competitors. The irony of such a statement coming from someone seeking to clone hedge funds seems to escape him.

(Lewis Braham is a freelance writer based in Pittsburgh.)

To contact the editor responsible for this story: Suzanne Woolley at swoolley2@bloomberg.net

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