Hedge Funds Moving Into a New Marketplace

By Murray Coleman

Hedging and indexing aren't two strategies normally associated with one another in the mutual funds marketplace.

But last week, the IQ Alpha Hedge Strategy Fund started being sold directly by IndexIQ. As observed at the time (see articlehere), it's got a rather pricey expense ratio for a no-load mutual fund. That's going to give the fund a big headwind to fight coming out of the gates.

Managers of the Goldman Sachs Absolute Return Tracker Fund [GARTX] face an even bigger challenge. Like the Alpha open-end fund, GARTX follows an index of various hedging strategies. The fund came out a bit earlier on June 10. But it not only has a more hefty expense ratio than most index mutual funds, GARTX's key retail shares come with a load.

The Goldman Sachs fund's A-shares charge an expense ratio of 1.6% and come with a 5.75% load; the C-shares charge a 2.35% expense ratio without any loads.

Although both are index-based products, other key differences are apparent from the start.

"While we call our fund an index, it's not a completely passive index," said Robert Whitelaw, chief investment strategist at IndexIQ and a finance professor at New York University's Stern School of Business.

The IQ Alpha Hedge Strategy Fund seeks to replicate six sub-indexes. "We take the hedge fund data from various sources and we create standalone sub-indexes replicating performances of different strategies," said Adam Patti, chief executive of IndexIQ.

The Alpha fund's sub-indexes cover: long-short, market neutral, global macro, fixed-income arbitrage, even-driven and emerging markets.

"Since there are more than 9,000 hedge funds in the U.S., definite trends show up in the market. Managers are making very similar bets," Patti said. "You can identify those bets and replicate it through a rules-based index."

Once the sub-indexes were formed, IndexIQ created an equal-weighted composite index. "We knew the factor weights of the sub-indices, so we're basically aggregating those on the composite index's level," said Whitelaw.

The index they watch most closely besides their own is the Credit Suisse Tremont Blue Chip index of hedge funds. "The back-tested data shows very tight tracking to the Tremont index going back five years," Patti said.

The Alpha mutual fund takes the composite's portfolio and optimizes weightings using exchange-traded funds. "We overweight and underweight each of those six strategies to reduce correlation to the S&P 500," Patti said. "Our research shows that optimization also tends to produce better returns."

In the hedge fund world it's common for funds-of-funds to do much the same. Managers of these umbrella-types of hedge funds will buy varying amounts of individual hedge funds based on their particular take on the market. "The difference is our product is strictly rules-based and it's fully transparent," said Patti.

GARTX sticks to passively tracking the Goldman Sachs Absolute Return Tracker index. "The GS-ART Index is not expected to have the same performance as actively managed products such as funds of hedge funds; it attempts to replicate the beta component only," according to Goldman Sachs.

Since both new funds will rebalance monthly, weightings can be expected to change frequently. But in the IndexIQ portfolio, by mandate one strategy can't represent more than 33% of its allocation. On the low end, it can actually go short the various strategies, up to a -16.67% position.

The fund's allocation as of May 31 was: a third in emerging markets; a third in event driven; a third in global macro; 13.33% in market neutral; 3.33% in fixed-income arbitrage and -16.67% in long/short strategies.

The result is that the IndexIQ fund functions somewhat like a 130/30 strategy, layering on additional alpha-seeking exposure while retaining 100% net long exposure to the market.

"The Alpha fund, based on back-tested data and real-time index data, would seem to provide slightly higher risk-adjusted performance and a little more volatility than the Goldman Sachs fund and its underlying benchmark," Patti said.

Unlike the IndexIQ fund, the index used by GARTX is based more on capturing beta performance than alpha. That means it focuses on volatility and trading ranges rather than trying to capture any outperformance of managers.

But like the Alpha fund, GARTX also uses sub-indexes to create a composite benchmark. Those come from other Goldman Sachs indexes covering hedge funds data relating to broad categories -- equities, commodities and fixed-income. Also tracked are hedging techniques based on credit and volatility measures.

The factors that comprise the GS-ART index are selected "from a universe of potential market exposures that contribute to hedge fund performance," Goldman Sachs says in the fund's prospectus.

Which ones it'll use are to be determined each October as part of the fund's annual selection process of underlying indices (or component market factors, as Goldman Sachs likes to term them).

GARTX also has a broader range of assets at its disposal. Those include futures, swaps, ETFs, commodity structured notes, stock and cash securities.

But IndexIQ argues that its practice of using only ETFs in the Alpha fund introduces more transparency into the process. "It helps to bring more liquidity into the hedge fund world and provides a better view of just what investors own," Patti said.

IQ Alpha Hedge Index Holdings (5/31/2008)

Ticker	Name	Weight (%)
SHV	iShares Short Treasury Bond	39.3
BND	Vanguard Total Bond	31.68
VWO	Vanguard Emerging Markets	30.69
FXE	CurrencyShares Euro Trust	12.63
CFT	iShares Lehman Credit Bond	12.32
DBV	PowerShares DB G10 Currency	10.00
PCY	PowerShares Emerging Debt	4.76
HYG	iShares Hi Yield Corporate Bond	1.58
DJP	iPath Dow Jones-AIG Commodity	1.18
TIP	iShares Lehman TIPS Bond	0.41
VNQ	Vanguard REIT	-3.42
IWM	iShares Russell 2000	-6.23
EFA	iShares MSCI EAFE	-9.90

Source: IndexIQ

 

Comments

[najdorf]

The (misnamed) IQ fund should be able to lock up the market of "investors" who would like to pay 1.6% expenses to hold widely-known ETFs with expense ratios of .11% (Vanguard Bond). My head spins at how many stupid ideas I've just learned about from this one fund.

What's the value in tracking 9,000 hedge funds? I mean, maybe the top 10, 100 or 1000 have some market-beating potential, but how is it even conceivable to anyone that hedge funds 1000-9000 are going to outperform mutual funds or indexes?

How does holding a bunch of ETFs lead to tracking hedge funds? Hedge funds reveal little information about what they do with a long time lag, trade frequently, and engage in strategies you can't get with an ETF. If you could match hedge fund returns by investing in some of the most popular ETFs according to a mathematical formula, why wasn't somebody already doing this?

Let's assume that a hedge fund index is reasonable and possible. This fund isn't even doing it! They're changing weightings monthly according to some sort of ill-explained modeling.

The guy that runs this company thinks hedge funds are an asset class (quoted in linked article). He must know this isn't true. Hedge funds are a managerial strategy. The asset classes are listed right above here in the holdings - bonds, REITs, stocks, currencies, commodities, etc. These are the same things anyone invests in, usually at much lower expense levels than this fund. What matters is strategy, and this fund has one of the most dubious ones I've ever seen (unless we're talking about a strategy for managerial enrichment).

[najdorf]

I did some further reading at

www.indexiq.com/downlo...

It appears that the actual hedge fund index is in the unfortunate position of trailing the S&P 500 over the past 5 years. So these guys made up a new hedge fund index via backtesting...that is, they looked back in time and figured out what sort of hedge fund index would have beaten the S&P by enough to make their fund seem like a good idea. This is kind of like looking back in time to find out that investing in Berkshire Hathaway, Walmart, and Microsoft would have been a good idea a long time ago, then creating a mutual fund that attempts to mimic the returns of having invested in those companies in a forward direction. Also the really high expenses and tax costs will wipe out a lot of this imaginary return. I can't believe this product exists.

[ZardozZ]

Just one more example of a market gone crazy...