Hedge fund ETFs ruffle active managers

Institutions may not favour volatile, high-beta hedge fund replicators, critics say

rollercoaster

As soon as hedge funds were required to disclose their equity holdings to regulators, it seems inevitable that others would set up funds designed to ape these holdings.
 
But it is yet to be seen whether these hedge fund exchange-traded funds (ETFs) – and other funds that replicate hedge funds at a cheaper rate – will pose a threat to the fund of hedge funds (FoHF) community and pique the interests of institutional investors.
 
“If I were a fund of hedge funds, I would be very anxious right now,” says Maz Jadallah, chief executive of AlphaClone in San Francisco, which has set up a number of hedge fund ETFs. He says his company offers access to the best hedge fund investments, which is what a FoHF is supposed to do.
 
Another provider compares such copycat funds to Uber, the Silicon Valley firm that is unsettling taxi drivers worldwide.
 
Critics say that a retail market may exist for cheap hedge fund ETFs, but institutional investors will be harder to win over: hedge fund ETFs are too volatile, are mostly high-beta vehicles and big investors can get cheaper exposure to hedge fund returns anyway.
 
The iBillionaire Index has a beta to the S&P 500 of 1.03, the AlphaClone Alternative Alpha ETF has a beta to the S&P 500 of 1.1 and the Solactive Guru Index has a beta of 1.13. The beta of the Solactive Guru Small Cap Index to the Russell 2000 is 1.01.
 
Yet many market themselves as being paths to cheap alpha. “When it comes to the animal kingdom, an alpha dog beats a beta pooch any day of the week,” writes Nicholas Vardy, chief investment officer of Global Guru Capital.
 
However, Stuart MacDonald, formerly managing director of London-based Aquila Capital, questions a passive approach to hedge fund investing and thinks such investors are “not really replicating hedge funds at all”. They are a different type of investment, he says.
 
Naturally those that simply invest in hedge funds’ favoured equities, without any short positions, will tend to rise and fall with the S&P 500. Many hedge fund ETFs offer a bull market strategy, thinks Anne-Gaelle Pouille, portfolio construction group member at FoHF PAAMCO in California. “As soon as the market becomes less benign, you run the risk of serious drawdown,” she says.
 
Pension funds looking for low-risk investments that do not correlate with the rest of their portfolio may look elsewhere. Those looking for equity-like returns may simply just invest in equities.
 
The iBillionaire Index has an annualised volatility of 14.1%, the Solactive Guru Index has a volatility of 14.7% and AlphaClone’s Alternative Alpha ETF has a volatility of 17.6%.
 
Each has a different method of replicating hedge fund returns. iBillionaire, an ETF index provider that launched in 2013, started as a mobile app that tracks billionaire investors’ stock picks. The 30 equities in the iBillionaire Index are the most popular holdings among 22 chosen billionaire investors – such as Carl Icahn, George Soros and Ray Dalio – as revealed quarterly in 13F disclosures.
 
Raul Moreno, New York-based chief executive of iBillionaire, reckons that the index is “the most affordable way to follow hedge funds”. The ETF charges 65 basis points, with no performance fees. The company targets a younger demographic: it says financial advisers and retail clients are the main investors, 45% of whom are less than 35 years old.
 
Solactive, the index provider behind the Guru hedge fund ETFs, has a more complex methodology. It selects about 30 managers from a pool of 100 hedge funds on performance and portfolio-turnover criteria. The managers are updated yearly, and the 52 equities on Solactive Guru Index are the managers’ top holdings.
 
“The index gives you a rules-based approach to replicate what hedge funds do,” says Steffen Scheuble, chief executive of Solactive in Frankfurt, who thinks there is value in a good methodology. “The 13F filings are publicly available, so in theory everyone can replicate that, but is it easy to copy and replicate? No.”
 
One problem is that hedge fund replicators will be following hedge fund positions more than three months after they have been disclosed to the Securities and Exchange Commission. iBillionaire, for example, rebalances its portfolio every quarter. If an equity sell-off happens, the ETF will be late to exit the particular position.
 
But AlphaClone’s Jadallah says this weakness can be overstated. “Hedge funds tend to have a long holding period,” he says. “For fundamental bottom-up hedge fund managers, holding periods tend to be about a year and high-conviction positions can be longer than that.”
 
AlphaClone’s Alternative Alpha ETF selects 20 or so managers from a pool of 500 fund managers, based on its ability to clone their publicly disclosed positions. The ETF then selects 80 equities with the highest long positions.
 
The ETF also has the ability to go short. When the S&P goes beneath its 200-day moving average on the last day of the month, the ETF goes 50% long, 50% short. The ETF’s beta will therefore decrease in years of bearish equity markets.
 
Investment advisers and retail investors form the bulk of AlphaClone’s ETF clients, but Jadallah has ambitions for a higher uptake among institutions. “It is definitely an institutional product, but it is just a question of timing,” he says. The Alternative Alpha ETF charges 95 basis points, far less than the traditional two and 20.
 
But will institutional investors be attracted by the lower fees? Large institutional investors should and do already have the clout to get hedge fund fees down, thinks PAAMCO's Pouille, in some cases to around one percent management fee and a discounted performance fee. Much of that price factors in risk management and due diligence, which are missing in clone ETFs.
 
Solactive, for example, performs little due diligence into the hedge funds or companies in which it invests. “What is the value of such an extensive due diligence?” asks Solactive’s Scheuble. “We only include [in our index] hedge funds that are big enough. At least a few people have already done due diligence before investing in such a hedge fund.”
 
Other critics worry that if hedge fund ETFs were to replace FoHFs, liquidity problems could result as it would be easier for investors to pull out money. In fact, investors could pull out their money quicker than ETFs could close their positions.
 
Pouille lists further difficulties facing replicator hedge funds. Hedge fund ETFs tend to invest in the most overcrowded trades, which may reflect an overvaluation, and they have a bias towards large-cap equities and high-beta names. For instance, Alternative Alpha ETF has a 23% exposure to tech stocks at the time of writing, compared with 18% in the S&P 500.
 
What’s more, thinks Pouille, disclosed long positions may simply reflect hedges for alpha short positions. Nonetheless, despite the problems, this unconventional approach to hedge fund investing may stick around for a while – in which case FoHFs will have to get used to it.

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