The latest rage in the financial services industry is to create “hedge fund replicators”: computer-driven tools that combine assets in a way that mimics hedge fund returns at a fraction of the cost. Goldman Sachs, Morgan Stanley and JP Morgan are all working in the space, developing replicators largely for the institutional market.
The newest entrant into the field is IndexIQ, which is hoping to introduce hedge fund replicators targeted at sophisticated retail investors. IndexIQ said earlier this week that it will unveil a “HedgeIQ” suite of “synthetic hedge funds” strategies, which will use portfolios of ETFs to track the performance of the ten investable Tremont Hedge Fund sub-indexes. The group plans to offer low-cost mutual funds and separately managed accounts that will track each of the ten indexes.
“For years, the highest quality managers and best performing investment strategies have been nearly exclusive to the institutional and ultra high net worth markets,” said Adam S. Patti, Chief Executive Officer of IndexIQ, in the official press release on the topic. “Our HedgeIQ suite of products democratizes the investment management industry by replicating the characteristics of sophisticated hedge fund strategies in a low-cost, risk managed, easy-to-understand manner.”
Patti’s statement both over- and understates the attractiveness of the new products. The truth about hedge fund replicators is:
1) Hedge fund returns actually aren’t that good;
2) These new tools are better than most hedge funds.
Recent Returns, Higher Hopes
For all the cache associated with “hedge funds,” the real returns just aren’t that great – something Patti was quick to admit.
“Ten or 15 years ago … hedge funds were run by the best of the best,” said Patti. “Now, you’ve got 9,000 hedge fund managers, and the quality has gone down. A lot of these hedge funds are nothing more than stock picking vehicles, similar to active funds.”
Active funds, that is, with exaggerated costs. The average fee for a mutual fund in 2005 was 1.13 percent, according to the Investment Company Institute. Many funds have loads and charges on top of that, but still, the total cost comes nowhere close to what hedge fund investors pay. The going rate for a hedge fund is a 2 percent annual fee plus 20 percent of any gains, figures that don't even touch on the topic of transaction costs or tax liability, which can be sky-high in the hedge fund space. The major hedge fund indexes haven’t beaten the S&P 500 since 2002, and their performance even in the post-2000 bear market (when hedge funds are supposed to shine) has been nothing to write home about.
Patti’s new hedge fund replicators, however, will use ETFs to construct portfolios of non-correlated assets (commodities, currencies, stocks, bonds): total fees will likely be less than 1 percent, annually. As the old Bogle saying goes, “in investing, you get what you don’t pay for.” By definition, these lower fees will translate into higher returns for investors.
Moreover, as (essentially) index funds, the new replicators will come without the one-off risk of certain hedge funds. While the name "hedge fund" implies that these funds manage risk, the experience of Amaranth and other blow-ups show that the large-scale risks do exist in the space.
The truth is that the best hedge funds – the ones you read about in the papers – are closed to new investors. The nouveau hedge funds that have launched in such abundance over the past few years are little more than prestige shops for people who want to mention “their hedge fund ” during cocktail hour.
The Tremont Hedge Fund indexes that IndexIQ’s new funds will track do a better job for most investors. They’re not going to blow the market out of the market – as mentioned, they’ve trailed it each year since 2002 - but they should have somewhat less volatility than an all-stock portfolio, with a reasonable risk/return tradeoff.
“The first strategies will cover the absolute return, long/short and emerging markets indexes,” said Patti, although IndexIQ will eventually lay out all 10 sub-indexes.
IndexIQ and the other companies launching these funds are, in a sense, returning hedge funds to their roots … actually providing a hedge against market volatility. That’s not for everyone, but for folks paying 2&20 to “real” hedge funds, it has to look like a good idea.