Institutional and high net worth money has been pouring back into hedge funds. According to Hedge Fund Research, which collects data directly from over 2,000 fund managers, hedge funds attracted $23 billion of net new capital in the third quarter of 2013 for a fifth consecutive quarterly record. All told, hedge funds manage $2.5 trillion, according to HFR, compared to the $14.6 trillion mutual fund industry.
But for some advisors, these investments have frequently been too risky or pricey for their clients. Until recently, only "qualified investors" and institutions could invest in hedge funds and even for a qualified investor, a hedge fund investment hasn't always been ideal: the minimums are high, usually over $1 million and commonly over $3 million, and the funds often charge a 1.5%-2% annual fee plus 15%-20% of any profits. So, an 8% return in a hedge fund becomes a 4%-5% return to the investor.
But increasingly, the mutual fund and ETF industries are offering new products that promise to capture the benefits of hedge fundswhich, ostensibly, include low correlation to other asset classes and absolute returns in all market cycleswithout the high fees and minimums, low liquidity and manager concentration risk of traditional hedge funds. This shift is being facilitated by a recent change in SEC rules.
Hedge Fund Mutual Funds
Hedge funds have historically been structured as limited partnerships, and new regulations require that most of these partnerships must now be registered with the SEC. Hedge funds are looking to make lemonade out of this enforced transparency. They're making their platforms 40-Act-compliant so they'll be eligible for inclusion in mutual funds, a strategy to gather more assets from a broader investor base.
Neuberger Berman is promoting its Absolute Return Multi-Manager Fund (NABAX, NABCX) with the tagline, "1,000 ideas, 10 managers, 1 fund." The fund, opened in May 2012, had its largest single fund exposure on October 31, 2013, with 14% of assets with Soundpoint Capital in distressed credit, followed by 25% of assets in a long/short equity split between two funds: Cramer, Rosenthal, McGlynn and Lazard Asset Management. Holdings are posted quarterly, including short positions which on September 30, 2013, included the stocks of Pioneer Natural Resources, Lennar and Sirius XM Radio. NABAX rose 9.6% in 2013, according to Morningstar.
Another of these new hedge fund mutual funds is the Franklin K2 Alternative Strategies Fund (FAAAX), started in October 2013. The fund has nine managers in four categories: event-driven, global macro, long/short equity and relative value. At the end of October, the fund was 91.3% long and 35.3% short, using leverage to invest more than 100% of assets, but lowering risk by investing both long and short. Managers include P. Schoenfeld Asset Management in event-driven and Chilton Investment Company and Jennison Associates in long/short equity, among others.
Fees for these new funds are higher than long-only mutual funds, and many have different classes of funds with and without an upfront load. Like the Franklin and Neuberger funds, most are fairly new and do not yet have long-term track records. Few have been tested in a major downturn.
Hedge Fund Replicators
An exception, IndexIQ's Alpha Hedge Strategy Fund (IQHIX), launched before the 2008 meltdown, did offer protection to the downside. The fund falls into the category of "hedge fund replicators." A totally different strategy than the mutual fund of hedge funds, IQHIX was the first open-ended no-load hedge fund "replicator," intended to perform like an index fund of funds.
The idea behind hedge fund replication is that the majority of hedge fund returns after fees is due to exposure to markets, or beta, rather than to the skill of the manager. Any skill benefit is assumed to be captured by the manager in the form of fees. The replicators aim to give investors exposure to the average hedge fund after fees, ideally offering steady returns with low volatility, high liquidity and transparency.
Computer algorithms identify likely exposures by asset class from hedge fund performance, collected by a handful of hedge fund tracking companies such as Hedge Fund Research. Then, the algorithm replicates those asset exposures in a portfolio, usually monthly, coming close to emulating overall hedge fund performance after fees.
The Alpha Hedge Strategy Fund, rated bronze by Morningstar, dropped 8% from its start in July 2008 to December that year, according to the company's website, and then increased 14.9% in 2009, according to Morningstar data. In comparison, HFR's fund of hedge funds index fell 21.37% in 2008 and regained only 11.47% in 2009. Since then, hedge fund replicators have consistently underperformed the stock market, as would be expected in a strong up-market because of the short positions carried by the funds they are imitating.
IndexIQ subsequently launched an ETF, Hedge Multi-Strategy Tracker (QAI) to follow the same multi-strategy index as the mutual fund. The ETF's assets surpassed $600 million in 2013, more than doubling from the end of 2012, according to the company. The fund gained 5.5% in 2013, according to Morningstar.
"QAI is the S&P 500 of the hedge fund market," says IndexIQ founder and CEO, Adam Patti. "We've been positioning this as a fixed income alternative." QAI's performance looks anemic compared to 2013's huge stock market move, but hedge fund replicator managers argue that the fund also serves the purpose of protecting from big moves down.
The ProShares Hedge Replication ETF began in 2011. HDG has a similar strategy to QAI, the same 0.95% expense ratio and had similar performance in 2013.
Two popular ETFs, GURU from Global X and ALFA from AlphaClone, attempt to capture both the beta and the alpha from hedge funds in a tradable ETF. "Why do we need to give up on alpha?" asks AlphaClone founder and CEO Mazin Jadallah. His research on hedge funds reveals that hedge fund holding periods can be surprisingly long and that the vast majority of hedge fund performance is from long, not short, positions. This research suggests that if some hedge fund managers are superior stock pickers, then, even with the late notice of waiting until positions are revealed via SEC filings 45 days after the end of each quarter, advisors can benefit by following suit.
Both ALFA (0.95% expense ratio) and GURU (0.75% expense ratio) have their own proprietary indexes created from top stock holdings of favored hedge funds. GURU handily outperformed the stock market with a year to date return of 42% in mid-December. Each quarter, it chooses the top 50 stock holdings of a pre-screened group of hedge fund managers who tend to buy and hold their favorite names. The positions are equal weighted and adjusted at the beginning of each quarter after the SEC filings become public.
ALFA has a similar strategy with a twist; the whole portfolio can go equally long and short in response to a technical stop-loss signal built into its strategy to protect against a prolonged market decline. So far, since inception in mid-2012, ALFA has stayed long and was up over 33% in mid-December. Both funds are still new and have not been "stress-tested" in a down market. These funds tend to hold large capitalization stocks.
So, whether you want to invest in a fund of hedge funds through a mutual fund, replicate the long/short exposures to worldwide markets of the average hedge fund or try to capitalize on the intellectual capital and research edge of the leading hedge fund managers, there is a "liquid alternative" hedge fund vehicle to consider. And as always, there are many more on the horizon.
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