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“If you want, you can re-create hedge funds in a low-cost way”

Date: Wednesday, December 19, 2012
Author: Ahila Karan, ProHedge.co.uk

New study demonstrates investors can use passive portfolios themselves to outperform hedge fund managers. According to a study for the Wall Street Journal by William Bernstein, investment manager at Efficient Frontier Advisors Investors, “if you want, you can re-create hedge funds in a low-cost way,” avoiding the high risk outsize bets taken by hedge fund managers.   

Most importantly, risk factors driving hedge fund performance must be understood. Bernstein highlights three main factors, which explain 80% of an average hedge fund’s performance: beta (stock movements in relation to overall market), size (market capitalisation) and style of the stock (value of growth).

Bernstein demonstrated that an investor can put together a passive portfolio with two ETFs plus cash, which will outperform the HFR Composite Index after fees. One ETF tracks the Russell 3000 Index (98% of stock market) and the other tracks the Russell Index “growth stocks” (high price to book values).

The success of the passive portfolio varied according to the hedge fund strategy replicated; the equity hedge fund replication outperformed HFR Equity Hedge index, however Relative-Value and Event-Driven replications failed to outperform their respective indices.

Bernstein’s analysis also showed passive portfolios would fail to replicate Macro funds, since these funds jump around. If the factor exposures change, the passive portfolio becomes ineffective.

Rye Brook, N.Y.-based IndexIQ, houses a suite of ETFs and a mutual funds that track hedge fund strategies by changing factor exposures over time. CEO Adam Patti has found this enterprise has attracted institutional investors recently.

Other managers, including Ramius Alternative Solutions, replicate portfolios of funds with the best future prospects. Vikas Kapoor, co-head of Ramius, however warns that “if you replicate a bad portfolio, even if you do it well, there will be a bad outcome.”