ETFs cash in by copying hedge fund stock picks, but some see risks

Date: Monday, February 24, 2014
Author: Reuters

Small investors who have longed to benefit from the brains of top hedge fund managers can now purchase those same stock picks without paying hefty fees or tying up a large amount of money.

The catch is that Global X Funds and AlphaClone LLC's exchange-traded funds are essentially mirroring top hedge fund holdings without the day-to-day hedging that is supposed to provide a cushion.

When certain top hedge managers buy a stock, New York-based Global X and San Francisco-based AlphaClone do, too, though with a lag that some critics say could be costly.

Still, returns from both funds last year far exceeded those of the hedge fund industry as a whole. AlphaClone's Alternative Alpha ETF was up 36.12 percent in 2013, a year when the average hedge fund returned 9.3 percent. And the Global X Guru fund gained 47 percent.

"If you know what every large investor in the U.S. owns in his portfolio on a quarterly basis, there is value in that information," said Global X head Bruno del Ama, who is planning to introduce two similar funds in coming weeks, as soon as they clear regulatory approval.

But it is not clear how such funds, which benefited from a strong market last year, will perform in more-volatile or down times, when hedge funds might be expected to fare better.

The ETFs build their stock lists from the 13F reports hedge funds must file with the U.S. Securities and Exchange Commission 45 days after the end of each quarter. The hedge fund therefore buys a stock much earlier than the ETF and does not generally disclose why it did so or how long it plans to hold the investment.

By the time an ETF has bought a stock, the hedge fund may have already sold its position, or the shares may have moved up substantially from the hedge fund's purchase price.

Furthermore, the Global X ETFs are designed to use only a part of the hedge equation: buying the long bets of a carefully constructed portfolio without protective hedges like short positions in offsetting derivatives.

"What you end up with is a fairly different entity" from a hedge fund, said John Rekenthaler, vice president of research at Chicago-based Morningstar. While an ETF is low-cost, liquid and transparent, "you give up quite a bit when you're looking at filings, which is old information, and long-only information."

Chips and Drugs

The Guru fund's biggest bets are on Netherlands-based NXP Semiconductors NV and Micron Technology Inc., two companies that have been popular with hedge managers. Top holdings in the Alternative Alpha ETF are Canada-based Valeant Pharmaceuticals International Inc. and New York-based American International Group Inc.

So far this year, the Guru fund is down about 2 percent, and the AlphaClone fund is up about 4 percent. The Standard & Poor's 500 stock index is down about 1 percent, and the HFRI Fund Weighted Composite Index, a broad hedge fund industry measure, has fallen about 0.5 percent.

The ETF managers boast that their fees are much lower than those charged by hedge funds, which also often require certain minimum investments.

"We wanted to be as accessible as possible," says AlphaClone founder Mazin Jadallah.

Annual management fees are 0.75 percent for the Guru fund and 0.95 percent for Alternative Alpha, compared with 2 percent plus additional performance fees for the typical hedge fund. But the ETFs are probably more like traditional actively managed stock mutual funds, whose annual fees average about 0.77 percent, according to a 2013 report from the Investment Company Institute.

The success of the Guru ETF, which has amassed some $563.6 million in assets since its inception in June 2012, and client demand have prompted Global X to offer two new copycat funds as soon as the U.S. Securities and Exchange Commission signs off on them. One will focus on shares of small companies, and another will include international stocks.

The firm uses added filters when choosing which hedge fund holdings to include in its ETF. For example, it excludes hedge funds that report less than $500 million in holdings or that have high turnover rates for their equity positions.

Whether the new ETFs will gain the same level of investor interest that the Guru and Alternative Alpha funds did in 2013 remains to be seen.

AlphaClone has not yet announced plans for any new ETFs.

Early investors in the Guru ETF were primarily retail investors, but del Ama said he expected more institutional clients to take an interest as the ETFs gain more assets.

The London Pensions Fund Authority may invest in the Guru fund, Chief Investment Officer Alex Gracian said.

"It gives you more diversification in terms of strategy type at a lower cost," said Gracian, who oversees nearly 5 billion ($8.3 billion) of pension funds. He said he might use the ETF to replace another long-only investment.