Hedge Fund Replication Strategies

[HenryTo]

Not sure if any of you have read this but would be interested to know what you think of these strategies. The links to the various papers quoted in the article are located at the bottom of the page:

http://www.economist.com/finance/displaystory.cfm?story_id=8086854

[HenryTo]

FYI, courtesy of FINalternatives:
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In Depth

Q&A: Hedge Fund Replicator Earns Its Stars

Aug 10 2011 | 4:04pm ET

For it's third birthday, IndexIQ's flagship open-end, no-load hedge fund replication mutual fund got what every young mutual fund craves—a five-star rating from Morningstar Inc. The IQ Alpha Hedge Strategy has managed a 5.73% return since its inception. FINalternatives spoke to CEO Adam Patti about the origins of his company, his love for exchange-traded funds and his mission to “democratize alternatives."

What is your background? What are the origins of IndexIQ?

Right before I started IndexIQ I was working at Time Warner. One of the main things I was doing was running a business unit called Fortune Indexes, which was the indexing operation related to Fortune magazine. We created indices based on Fortune magazine lists and worked with State Street Global Advisors to bring out ETFs based on those; we did that way back in 2000, really early in the ETF market. Those products were the first non-market-cap-weighted indexes, what people now call “fundamental” indexes.

Our flagship product was the Fortune 500. The interesting thing about it was that it outperformed the Standard & Poor's 500 Index over most timeframes going back 50 years, with lower volatility and higher dividend yields. So that’s kind of when the light bulb went off

So, long story short, I pulled the team out of Fortune Indexes and started the company in 2006. The goal was, really, to democratize alternatives and try to apply these index-based methodologies to more sophisticated institutional class alternative strategies and in doing so, add value for investors, improve transparency and liquidity, reduce fees and improve tax efficiency. I thought if we could do that, and offer it wrapped in an ETF structure, that might be the Holy Grail. I’ve been smitten with ETFs since I started working with them early on. I think they’re the universal tool.
We’re really a research-driven organization. Most ETF issuers out there, they license indexes from others and then package them and sell them; they’re really more sales-driven. We develop everything ourselves and to do that, we knew we had to hire some really good research people. We attracted Professor Robert Whitelaw, who is chairman of the finance department at New York University, to be our chief strategist. He’s been with us since day one, and we brought on some additional academics to fill out our academic advisory board. Then we built out our core research team—we hired Sal Bruno, who was the former global head of quantitative research at Deutsche Asset Management, and we built around him and that’s the organization.

How do you construct one of your hedge fund replication funds?

The issue is that you’ve got as many hedge fund managers as you have mutual fund managers, and we all know that 85% of active mutual fund managers underperform their benchmarks every year—because it’s tough! It’s tough to drive alpha. So the academics, including Whitelaw, in the ‘90s started looking at hedge fund returns and trying to determine what are hedge funds really providing. Lo and behold, what they’re providing is a lot of beta exposure, not that much alpha. Which isn’t surprising, again, because there are only so many market inefficiencies to exploit. Now what they found is that the beta the hedge fund managers are providing is actually very valuable, it’s a multi-asset class beta, it’s not S&P500 equity beta, it’s diversified stream of risk premia across different asset classes.
So then the question is, can you replicate that beta? And the answer is, "yes." The academics proved, beyond any reasonable doubt, that you can replicate what they were calling "alternative beta" by using liquid securities commonly used in the marketplace. And that’s what we are the leaders of the world in doing—we were the first firm in the world to launch a full family of indexes that replicate six of the top hedge fund strategies, from the market neutral to long/short equity to global macro and so forth.
These six hedge fund replication indexes have been calculated live by Standard & Poor’s since March 2007. Each one of these indexes uses ETFs in the portfolio as the proxies for the asset classes that hedge funds in those categories are using. We’re not trying to be a hedge fund, we’re not trying to beat hedge funds, we’re not trying to do any of that: We’re trying to be the hedge fund market.

Your flagship product is a mutual fund. How difficult is it to replicate hedge fund strategies within a mutual fund wrapper?

Each one of those six indexes covers one strategy; think of them as building blocks. The mutual fund is almost like a synthetic fund of funds. We’re always invested in all six of the strategies, it just depends on the degree. Just like a fund of funds manager will look at his or her managers and decide where the momentum is and who’s doing well, that’s exactly what the mutual fund does in a rules-based way—it looks at the momentum of returns, and the correlations and the volatility and based on that reallocates among those six strategies on a monthly basis.

You described ETFs earlier as a “universal tool." What is it you like so much about them?

The beautiful thing about ETFs is that they’re cheaper, typically, than mutual funds. You can buy and sell an ETF all day long because it’s pricing constantly, you don’t have to wait for the end of the day as with mutual funds. And most importantly, tax efficiency, particularly with a more sophisticated strategy like a hedge-fund-like strategy—neither one of those has ever paid out capital gains on portfolio turnover. So that’s a huge advantage.

How do your products fit into average portfolio? Who is target investor?

That varies a little bit depending on who you are, but generally, all investors now are encouraged to have some type of hedge fund allocation. The trick, of course, is how you get that hedge fund allocation if you can’t invest in hedge funds—that’s where our products come into play. Smaller investors or less-sophisticated ones could use QAI or MCRO or our mutual fund as their entire hedge fund allocation. All these products are designed to hedge volatility—to reduce volatility in a portfolio and provide upside potential when the market goes up but protect your downside,; they’re safety-type products, they’re not shoot-the-lights-out hedge fund products.
Others—more sophisticated investors or investors that have access to the best hedge funds in the world—can use our products simply as a cheap alternative beta core. Say you have 20% in hedge funds: Use our products for 10%, don’t pay alpha fees for beta performance, which is what you’re paying when you’re paying most hedge funds. Use us as the core and then find those really stellar managers as satellites.

We haven’t touched on the issues of transparency or liquidity yet, but I’m guessing those are significant selling points for your products.

It’s funny: When we launched the products initially—the mutual fund was the first one we launched—we thought it would be about fees, and then, all of a sudden, the world changed. Fees are not even on the table anymore—I mean, we have the cheapest fees in the world, I think, for our product. But it’s all about liquidity: "Can I get in and out when I want?" and "Do I know what I’m buying?"

Every day on our Web site—this speaks to the value of ETFs, but we also do it for mutual funds because it’s our philosophy—you can download the updated portfolio components, and understand exactly what you own, every day.

And also, with our index products, there’s no active manager so we have our rule book right on our Web site that shows you how the index is run. So every day you can see what’s going on and why something’s happening.

What does a Morningstar five-star rating mean to you?

It's validation that we’re trying to build quality products as a small company. We’ll never have 100 products out there. We have a very small number of products that we put a lot of care into building. We test them and we make sure they work before we launch them and I think the Morningstar rating really just proves what we’re trying to do is working and, I think, validates hedge fund replication. When we launched these products everyone thought we were crazy and now I think it’s becoming more mainstream.

How mainstream are these products now?

Well, when we launched it, nobody knew what it was; we’ve been out there educating people for three years, so I think advisors much better understand what we’re trying to accomplish and how you use it. I think the average person on the street won’t have any idea, but I think most advisors, at least advisors who use hedge funds, they’ll know what this is. That’s a big win for us.

[rffrydr]

Of "Power Outages" and "sick days": trading off the trading floor.

http://ftalphaville.ft.com/blog/2010/03/02/162276/subprime-short-from-the-beginning/
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Today is the Tomorrow you worried about Yesterday!

[rffrydr]

The Madman makes a good point: hedge fund, esp. of the recently reminted variety, cannot afford two down months at the start of the year. Selling is self-preservation.
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Today is the Tomorrow you worried about Yesterday!

[rffrydr]

Thanks for that, Bill. I think we see the rationalization for all the black-box trading this last few years. And the marked change in market character. That alpha dive to zero was probably enough for most institutional money; and the (not) surprising ascendancy of the "convertible bond" model to explain most hedge-fund returns is symptomatic of this last bull cycle driven by fear of the very markets themselves. 2000 will haunt for a long long time. Indeed indexing and even the "hedge-fund" itself is symptomatic of this era. See "Greed born of Fear" below.

[nodoodahs]

See exhibit 2 on page 7.
http://www.partnersgroup.com/docs/library/JAI_WI_05_Jaeger.pdf
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[nodoodahs]

Even the replication proponents in academe admit that there are idiosyncratic aspects of HF returns that they can't duplicate. Some even suggest going long several FOF and shorting a replication product as a "portable alpha" strategy.

Even so, as practiced by the players, it's about matching either the FOF index (or a strategy index) and not about matching any particular HF.

Read some more and found there are about 3 players out of more than a dozen that are actually shooting for some absolute return products at low-vol rather than mimicking the FOF indices. It looks like they are setting those targets to please institutional asset allocators and not shooting for the max possible risk-adjusted return, but at least a few are setting out in the direction I would take the technology.

Agreed there's lots of non-ETF-able ops for differentiation in today's market (and some in every market).

Edit to add: comment also in this thread http://www.marketthoughts.com/forum/viewtopic,p,35641.html#35641
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[rffrydr]

Einhorn did alright buying under(un)priced mortgage CDS. Nothing Buffett about that.

There are so many assets facing a binary outcomes it would seem there's never been a better opportunity for differentiation here. In fact that will be a condition to a any new bull market. And who's gonna ETF Steele Partners foray into japan this last five years?
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Today is the Tomorrow you worried about Yesterday!

[nodoodahs]

[HenryTo]

More hedge fund replication strategies coming. As mentioned in the previous posts on this thread, the vast majority of HFs don't add any alpha on a market/risk-adjusted basis, particularly after accounting for fees. The best HFs (including Buffett's best trades) involve either being a market maker or providing liquidity to the financial markets (such as Buffett's rescue of GEICO in 1976) - and most HFs are in no position to engage in this kind of transactions:
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Flood of ETFs promising hedge fund-style returns
Tue Jun 9, 2009 4:27pm EDT

By Joseph A. Giannone
NEW YORK, June 9 (Reuters) - Money managers are flooding the market with exchange-traded funds (ETF) and mutual funds designed to give even the smallest of investors access to hedge fund returns without all the usual restrictions or hefty fees.

IndexIQ Advisors, a start-up firm that seeks to replicate hedge fund performance, on Tuesday launched the index-based IQ Hedge Macro Strategy Tracker ETF (MCRO.P), about 75 percent focused on emerging markets and 25 percent on global trends. The offering joins the IQ Hedge Multi-Strategy Tracker ETF (QAI.P), which began trading in March and is up 17 percent.

Both ETFs charge a fee of 0.75 percent and invest in a range of ETFs, with the exact mix determined by computers looking to mimic hedge fund returns.

And there's a lot more to come. IndexIQ in April told the Securities and Exchange Commission that it plans to launch as many as 15 exchange-traded funds emphasizing different hedge fund strategies. The next offerings to come include a natural resources ETF, which will invest in stocks, and an inflation- hedged product buying a mix of commodity and equity ETFs.

"We intend to own the alternative investments space," said Tony Davidow, head of distribution at IndexIQ and former leader of Morgan Stanley's institutional consulting services. "We'd like to be the Vanguard of the hedge fund business."

The tiny firm, managing $100 million across a mutual fund, separate accounts and now two ETFs, is a long way away from catching up with the pioneer of the index mutual fund movement and its $1 trillion of assets.

And there is a growing number of competitors in this corner of the market.

Davidow says index funds offering hedge fund strategies can be beneficial to all investors, muting ups and downs and generating returns not tied to the overall market.

Since its launch nearly one year ago, the IQ Alpha Hedge Strategy IQHIX.O mutual fund has been flat, which is good compared with a 22 percent decline in comparable hedge funds and a 25 percent fall in the broader U.S. equity markets.

Disappointing hedge fund performance last year and redemption blocks have angered big investors and created a rare opening for new offerings. Firms such as IndexIQ, WisdomTree Investments and Grail Advisors intend to take advantage of the popularity of ETFs while offering strategies that used to be exclusive to the super rich.

San Francisco-based Grail Advisors LLC on Tuesday said it plans to launch four actively managed exchange-traded funds. RiverPark Advisors LLC will serve as lead sub-adviser for the RP Growth, RP Focused Large Cap Growth, RP Technology and RP Financial funds. Trading of these ETFs is expected to begin Sept. 1.

WisdomTree Investments, a money manager that has launched dozens of fundamental-weighted index ETFs, on Monday filed papers for three actively managed hedge fund-style ETFs: WisdomTree Real Return Fund, WisdomTree Managed Futures Fund and WisdomTree Long-Short Fund.

The lines dividing hedge funds and mutual funds have been fading over the past year.

AQR Capital Management LLC, a hedge fund firm with $20 billion under management, in January expanded into the mutual-fund business with the AQR Diversified Arbitrage Fund ADAIX.O. That was followed by its AQR Global Equity Fund AQGNX.O in February.

Highbridge Capital Management LLC, a unit of JPMorgan Chase & Co (JPM.N), has managed the JPMorgan Highbridge Statistical HSKAX.O Market Neutral mutual fund since 2005.

[HenryTo]

More quotes from the New Yorker article:

[HenryTo]

New Yorker article on hedge fund replication:

http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_cassidy?printable=true

[HenryTo]

Conquest Capital on hedge fund replication:

http://www.eurekahedge.com/news/07_july_Conquest_Hedge_Fund_Replication.pdf

I have not read the above paper and haven't studied hedge fund replication in great detail. But I have read (mostly from Andrew Lo of MIT) that most hedge fund strategies can be replicated, with the exception of "Event Driven" strategies, such as buying distressed debt.

[nodoodahs]

The main trouble with strategy is deciding what you want. After that, it's just a question of time and data.

I've not found anything impressive about any of the complicated hedge fund strategies I've studied, and nothing that can't be implemented by anyone, subject to capital constraints - some strategies take minimum levels of capital to enact.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.