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In recent years, some investment firms have offered products to mimic hedge fund returns to individual investors in the forms of ETFs or mutual funds. These products are under a variety of names, for example, hedge fund replication, alternative beta, hedge fund indexing or rule-based strategy. The objective of the products, according to their managers or sponsors, is not to deliver outsized absolute returns, but rather to provide diversification benefits to a portfolio of traditional asset classes. The products currently being offered range from multi-strategies, merger arbitrage, equity long/short, market neutral to global macro and managed futures.

In this article, I will discuss what kind of products will be most likely to deliver diversification benefits as well as return potentials.

Since majority of the funds have short histories, I will use the performance data of their underlying indexes for the study. In reality, most of the products are designed to track their underlying indexes.

  • Multi-Strategy Fund (QAI, ALT, GARTX)

Multi-strategy funds intend to replicate the performance of the broad hedge fund index with the market beta factors such as international equity index, emerging market equity index, bond index, real estate, high yield, commodity and currencies, etc.. By construction, this type of fund is a portfolio of market betas. As a result, the correlations between the strategy and market factors are relatively high. The correlations are shown in Table 1.

From the perspective of diversification, multi-strategy funds do not provide a lot of diversification benefits in a well-diversified portfolio. The expected return of the strategy is determined by the weighs of beta factors in the portfolio. The historical returns of the strategies are illustrated in Table 2.

The mutual funds and ETFs in this category include IQ Hedge Fund Multi-strategy Tracker (NYSEARCA:QAI), iShares Diversified Alternative Trust (NYSEARCA:ALT), Natixis ASG Global Alternatives (GAFAX), Goldman Sachs Absolute Return Tracker (GARTX).

  • Arbitrage Fund (CSMA, ADAIX, ADANX, MNA)

Merger arbitrage and convertible arbitrage are the most popular arbitrage-type strategies hedge funds employ. Merger arbitrage strategy aims to exploit the price discrepancies between the acquirer and the acquiree during the merger process. It earns risk premium because there is a possibility of a merger failure. Convertible arbitrage strategy intends to take advantage of the option mispricing and liquidity premium in the convertible bond markets. The arbitrage strategies, especially merger arbitrage, not only provide the most diversification benefits to any traditional asset allocation portfolio but also the best return potential. In my view, replication of the arbitrage strategies makes the most sense because its return does not only depending on the managers’ ability of generating alpha.

There are systematic risk premiums embedded in those strategies. Therefore, it will be easier for a hedge fund replication manager to generate returns. The arbitrage mutual funds and ETF’s include Credit Suisse Merger Arbitrage ETN (NYSEARCA:CSMA), AQR multi-arbitrage strategies (ADAIX, ADANX) and IndexIQ Merger Arbitrage ETF (NYSEARCA:MNA).

  • Macro Fund (NYSEARCA:MCRO)

Global macro strategy aims to profit from identifying long-term market trends in the equities, currencies, bonds and commodities. Its performance mostly depends on the manager’s ability to time the markets. In general, the strategy has a long bias in market factors. On average, the strategy has a high correlation with market movements. IndexIQ has recently offered a macro fund ETF (MCRO).

  • Equity Long/short (NYSEARCA:CSLS)

Equity long/short strategy takes long positions the manager think undervalued and short positions overvalued. Like macro strategy, its performance mostly depends on a manager’s ability of picking the right stocks. On average, the strategy has a long bias and is p correlated with market movements. Credit Suisse offers an equity long/short ETN (CSLS).

  • Equity Market Neutral (HSKAX)

Equity market neutral fund managers normally use quantitative models to identify long and short positions and construct a portfolio uncorrelated to market movements. The performance of the strategy mostly depends on how good the models are. By construction, the market neutral strategy has a low correlation with the equity markets. However, its return potential of the product varies with the model being used by each manager. There is no systematic risk premium to be captured in the strategy. Highbridge Market Neutral Fund (HSKAX) has been in the market for a few years.

  • Managed Futures (RYMFX)

Managed Futures managers, also called Commodity Trading Advisors, normally use a momentum or trend-following strategy in commodities, currencies, equity indexes and bond futures. The strategy has a low or negative correlation with market over a long term, especially in market turmoil. In a strong trending market, the strategy tends to perform well, but in a choppy market, it performs poorly. Behavioral finance theory predicts the trend-following strategy will work in the long run. Normally, the under-reaction of investors creates a market trend and over-reaction extends the trend. Rydex offers a mutual fund (RYMFX) that tracks the S&P Diversified Trend Index.

In conclusion, for an investor who is holding a portfolio of diversified asset classes, arbitrage fund and managed futures fund are most likely to provide the best diversification benefits and return potentials. Market neutral strategy can also serves as good diversifier, but its return potential could be limited since the performance of the strategy comes from a good model rather than some sort of systematic risk premium or long-term investors’ behavior bias.

click to enlarge images

Table 1: Correlations Across Various Strategies

Table 2: Annual Performance of Various Strategies

Notes:

  1. Data source: Bloomberg
  2. The data used here for GARTX, CSMA, CSLS, MCRO and RYMFX are the data of the underlying indexes. The actual history of the funds are too short for a reasonable analysis.
Source: Mimic Hedge Fund Returns With These ETFs and Mutual Funds