How Not To Create Your Own Hedge Fund

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 |  Includes: IUSG, VTHR
by: Roger Nusbaum

The WSJ had a peculiar article about how to use ETFs to "create your own hedge fund." The article isolated several hedge strategies, some recent performance data of these strategies at a broader index level and offered ETF combos to serve as proxies that would have delivered the same results for much less in the way of fees.

The suggested hedge fund replicating ETF combos came from research done by William Bernstein, who concluded that hedge funds can be mimicked with "varying amounts of just two ETFs, plus cash."

The two ETFs that Bernstein used for this were the iShares Russell 3000 Growth Fund (IWZ) and the Vanguard Russell 3000 ETF (NASDAQ:VTHR)--so a total market fund of sorts and the growth slice of the total market. To capture equity, relative value, event driven or macro hedge fund performance (the four categories cited in the article), all that needs to be done is combine the two funds and cash in different percentages. The article was not clear on the amount of time that was analyzed to draw these conclusions but there was a reference to how one of the combos did over the last two years.

The last time I looked at the article there was only one comment and it called the portfolios ridiculous.

Since the March 2009 low, hedge funds have broadly lagged the S&P 500, which the article attributes to hedge fund managers being too bearish (or skeptical?) for the last three and a half years. Stated another way, the various hedge strategies have lagged for being too bearish. One flaw in the article is that they did not set out to lag the S&P 500.

So equity hedge funds were up 6.3% annualized for the last two years which Bernstein says could have been equaled by putting 38% into IWZ, 16% into VTHR and the remaining 46% in cash. If the article is about how to mimic hedge funds, then there is a huge (and ridiculous) assumption that equity hedge funds will continue to track the same as the the two ETFs held in those percentages. What this article seems to offer is a backward looking coincidence and investing this way going forward is to assume the same coincidence will persist.

From a mimic the hedge funds standpoint, the article is worthless. Perhaps there is an argument to be made for the equity portion of a broad based portfolio to be split in some fashion between all cap and all cap growth (although I would not be the one to make it) but that is not what the article is about.

I do believe that the article is an attempt to teach newer investors something about portfolio construction - and that it simply is a bad article. The reason to write about this at all is that our country has a problem with financial literacy and articles like this will not help to solve the problem. As I have mentioned before, it is likely that individuals reading this blog (along with other blogs) are probably the person that close friends and family members go to when they have investing questions and you probably want to help them in some capacity. Steering them away from dreck like the above linked article can help solve the problem.