Hedge Funds? Forget It, Say ETF Experts. Try Replicating Them Instead.

IndexIQ’s Adam Patti, Greenrock Research’s Kevin Malone spell out how they replicate hedge funds with ETFs

The capital markets abhor a vacuum, and as exchange traded funds grow more popular, their uses keep multiplying to fill every space that their creators and investors can identify.

In the world of registered investment advisors, many RIAs are now working with ETF firms to create custom-made funds to suit their clients’ portfolios.

For example, New York-based ETF firm IndexIQ routinely consults with registered investment advisors about what they’re looking for, “where their pain points are” and problems with existing products in the marketplace, says CEO Adam Patti (left). And after doing the market research, IndexIQ custom-designs products capable of making Savile Row’s bespoke tailors turn green with envy.

“We talk to many clients who say, ‘You should launch an ETF based on this.’ Then we’ll compile that data and bring out a product,” Patti said in an interview on June 20. “Over the past couple of weeks, we have launched a Japan mid-cap product and a small-cap real estate investment trust product. Those were directly because of the conversations we’ve had in the field.”

Sometimes the ETFs that get created as a result of those conversations are relatively simple “pure play” creations focused on a single market niche, such as the aforementioned IQ U.S. Real Estate Small Cap ETF, which goes under the ticker symbol ROOF.

But other times, the quants on IndexIQ’s academic board create a more complex set of proprietary investments capable of making hedge fund managers turn red with rage. How? By using a rules-based philosophy that combines the beta benefits of traditional index investing with the high alpha returns sought by active managers.

In short, the firm designs cheap, liquid ETFs suitable for portfolios of any size that replicate the returns of expensive, locked-up hedge funds.

When an RIA recently came to Kevin Malone (left), president of Greenrock Research, which offers asset allocation strategies, Malone recommended an IndexIQ portfolio combining three hedge fund replication ETFs, a mutual fund and an absolute-return, inflation-hedging ETF:

  1. IQ Hedge Multi-Strategy Tracker ETF (QAI)
  2. IQ Hedge Macro Tracker ETF (MCRO)
  3. IQ Merger Arbitrage ETF (MNA)
  4. IQ Alpha Hedge Strategy Fund mutual fund (IQHIX), which is a mutual fund
  5. IQ Real Return inflation-hedging ETF (CPI)

“What happened was, the RIA called us and said, ‘George Smith has $50 million, and these are his goals. What should the portfolio look like?’ We worked collaboratively to come up with the asset allocation strategy,” Malone recalled. “When we got to alternatives, we said, ‘This should be half of your alternative

allocation, these IndexIQ ETFs.’ Then two months later, the same client called and said, ‘We’ve got this $100,000 portfolio. We used the same solution.’ That’s the brilliance of it—it’s not just the solution for a small client. It’s the solution because it has intellectual integrity. This is a great idea for anybody of any size.”

Malone pointed to Roger Ibbotson and Peng Chen’s 2011 study, “The ABCs of Hedge Funds: Alphas, Betas, and Costs” (Chen was president of Ibbotson Associates when Ibbotson sold the firm to Morningstar in 2006) which concludes that hedge funds between 1995 and 2009 have resulted in about 10% to 15% of alpha return, 60% to 65% of beta return and 20% to 25% in fees.

“Why would you pay hedge fund fees where you’re only getting alpha return that’s 10% to 15%? We think we have fee structures that are about a third or a quarter of what hedge funds are by using ETFs, and we’re probably going to get similar returns and have complete liquidity. That’s what we use IndexIQ for,” Malone said. “We could take our clients’ money out of those ETFs tomorrow. That’s why we are perfectly happy with beta. We can get beta as the core, like you would with an alternative investment fund of funds, and we can do it for a third or a quarter of the cost and have liquidity.”

The five IndexIQ funds achieve a similar return pattern to a hedge fund over approximately 18 months, Malone said.

“We studied those five funds and came to the conclusion that over time, those five funds should replicate hedge funds,” he said. “The core of one’s hedge fund strategy, we believe, should be a diversified group of funds similar to the diversified group of hedge funds you would get in an alternative investment fund of funds.”

The key, Malone said, is that ETFs can be invested in the very same asset classes that hedge funds invest in. “You can do anything in ETFs that you can do in hedge funds. We think hedge fund replication is the core of one’s alternative space,” he said.

IndexIQ’s Patti agrees.

“If you look at the hedge fund marketplace today, it looks just like the mutual fund market,” Patti said. “You’ve got 10,000 hedge funds in the marketplace, and you’ve got 10,000 mutual fund managers. We all know that 85% of

mutual fund managers generally underperform their benchmark in any given year. The same thing goes with the hedge fund marketplace. Everyone believes that they’re getting into the best hedge fund, and ‘my hedge fund is brilliant,’ but when there are 10,000 of them, and when you look at the return patterns, lo and behold, what hedge funds are providing in aggregate is a form of beta exposure.”

The S&P 500 Index, Patti explained, is the beta of the market, with a beta of 1. A lower or a higher beta than 1 translates as higher volatility or lower volatility. Alpha means the outperformance above the benchmark that is driven by manager skill, “and there is very little of that in the market,” Patti asserted.

Investors in hedge funds who lock up their capital for years and pay “exorbitant” fees—say, a 2% management fee plus 20% of profits —don’t get much alpha, he said. In comparison, according to Patti, IndexIQ's ETFs charge a fee of 69 to 79 basis points, or 0.69% to 0.79%.

IndexIQ’s replication of hedge funds involves studying the return patterns of hedge funds’ core asset allocations and then matching those returns using a quantitative process that the firm has built over the course of six years, Patti said.

“I don’t really care what an individual manager is invested in, because for every manager who’s invested long in GM and short in Ford, there’s another manager who’s invested long in Ford and short in GM,” he said. “What you find is that across categories, core asset allocation across management styles is similar. And the reason for that is simple: there are only so many asset classes that you can invest in. Stocks, bonds, cash, commodities, real estate and currencies—they are all invested in these same asset classes. The difference is what proportion they’re invested in and whether they’re long or short.”

When hedge funds first became popular in the 1980s, those managers were exceptional and delivering big returns, Patti said. “But fast forward to today. Now you have 10,000 hedge fund managers going after a finite number of market inefficiencies through which they would generate alpha. And hedge funds are using ETFs all day long. They may hate my ETFs, or at least a couple of them, but some of our ETFs are hedge fund replication ETFs, and they are heavily used by hedge funds.”

For an argument in favor of actively managed funds, read an interview with Green River Asset Management hedge fund founder Scott Vincent  at AdvisorOne.com.

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