Providing liquid access to hedge fund performance through an ETF wrapper is an appealing idea, especially in an environment of high correlation between asset classes. While they are still seen as an obscure asset class by many investors, we think that hedge funds can play a useful role in a diversified portfolio as they aim to deliver returns with low correlations to the broader market.
At present Europe is home to seven hedge fund ETFs offered by six issuers who use different structures and strategies to achieve hedge fund-like returns. The number of methodologies and their level of sophistication can be daunting and leave investors wondering what the differences between all the products are. In this article we will shed some light on the hedge fund ETFs currently on offer in Europe and discuss their advantages as well as their shortcomings.
Separating the Alpha from the Beta
First, it’s important to make a distinction between those ETFs that try to replicate hedge fund performance and those that track actual hedge fund performance.
Hedge fund replicators rely on the concept of “hedge fund beta”. This is the idea that a substantial portion of hedge fund returns can be explained by exposure to certain market factors (or “betas”), such as movements in the US equity market or exchange rates, rather than individual manager skill (or “alpha”). Hedge fund replicators seek to reproduce this hedge fund beta in a relatively liquid, transparent and cost efficient manner by investing in a set of rules-based strategies based on liquid underlying assets. Thus, they don't seek to replicate the alpha-seeking strategies of hedge fund managers. Today, there are two hedge fund replicators available in Europe, namely the Source BofAML Hedge Fund Factor ETF (SMLD) and the Goldman Sachs Absolute Return Tracker Index (GAQ1). Both use synthetic replication to track their reference indices.
On the contrary, the second category of hedge fund ETFs, i.e. those that track actual hedge fund performance, aims to provide exposure to the alpha-seeking strategies of hedge fund managers through either direct investment in hedge funds themselves or through synthetic replication of their performance. While the Marshall Wace TOPS Global Alpha ETF (MWTS) and Qbasis Futures Fund ETF use physical replication, the db x-trackers db Hedge Fund Index ETF (DX2Y) , db x-trackers db Equity Strategies Hedge Fund Index ETF (XHFE) and UBS-ETF HFRX Global Hedge Fund Index (UIQC) use swaps to mimic the performance of the underlying hedge funds that comprise their benchmarks.
In terms of exposure risk, there is also a difference between the ETFs that give access to a single hedge fund strategy and those that track multiple hedge fund strategies. By targeting absolute returns from single investment strategies, the Marshall Wace and Qbasis ETFs expose investors to single manager risk. In contrast, by aiming to replicate multiple hedge fund strategies, the db x-trackers and UBS ETFs provide diversification across strategies and managers.
To clarify, we have classified all the hedge fund ETF models currently employed in Europe as follows:
We think it’s important that investors be realistic about what to expect from ETFs that give exposure to hedge fund returns. Because of the illiquid, opaque and costly nature of the underlying asset class they track, investors shouldn’t expect hedge fund ETFs to offer the same advantages as mainstream ETFs. For each of the above products, investors will have to sacrifice at least one of the hallmarks of the ETF wrapper, whether it’s (i) full transparency–knowing the composition of the underlying portfolio at any given time, (ii) direct access–gaining representative and direct exposure to the sought asset class, or (iii) low costs.
Because ETFs tracking actual hedge fund performance can provide access to the real alpha stream of hedge funds, they have the advantage of being more representative of the broad hedge fund industry than replicators. However they lack transparency. While they regularly provide information on their strategies and the construction of their indices, they will never disclose the indices’ constituents on a security-by-security basis. These ETFs are usually not cheap either. They are actually among the most expensive we have seen thus far, with an average total expense ratio of 100 basis points per year in addition to the typical hedge fund fees which are embedded in their respective indices. These additional fees implicitly charged to investors include a 1.5-2.5% annual management charge and a 20-25% annual performance fee.
Hedge fund replicators can be considered as lower-cost alternatives. Their overall cost structure tends to be lower because they are cheaper to run (they use computer programmes) and they don’t have the hedge fund’s fee structure built into their models. Hedge fund replicators also tend to be more transparent because they typically invest in portfolios of liquid and well-known indices whose composition is regularly disclosed. However investors shouldn’t expect a replicator to deliver a performance fully representative of the broad hedge fund industry. Replicators by design cannot capture the full benefits of the most talented (or luckiest) managers. Also, they may not be able either to gauge or quickly adapt to current market conditions because they rely on backward looking factor replication models. Additionally, replicators are dependent on hedge funds reporting information to databases, which introduces a bias (reporting of returns is voluntary) and an additional time lag in replication. In fact, empirical studies* have shown that the risk-adjusted return of replicating strategies is often inferior to that of their hedge fund counterparts and very significantly so for some hedge fund strategies.
* Papers by Hasanhodzic and Lo (2007) and EDHEC Risk and Asset Management Research Centre (2009)
Read our analysis of the available European Hedge Fund ETFs:
-- db x-trackers db Hedge Fund Index ETF
-- db x-trackers db Equity Strategies Hedge Fund Index ETF
-- UBS-ETF HFRX Global Hedge Fund Index SF
-- MW TOPS Global Alpha ETF
-- Qbasis Futures Fund ETF
-- Source BofAML Hedge Fund Factor Euro ETF
-- Goldman Sachs Absolute Return Tracker Index ETF
