The problem with hedge funds

First, let’s look at complexity. The hedge fund sector is broad. Returns across the sector are dispersed very widely. Performance varies hugely from fund to fund. As some are generating strong returns, others languish far behind the wider market. We have known some funds to appear at both ends of the scale at different times. The chart below shows the dispersion of returns between the constituents of the HFRI 500 Index (leading benchmark provider Hedge Fund Research’s flagship investable benchmark) in 2020.

Source: ASI Hedge Fund Research October 2020. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index. Past performance is not an indication of future results.

An investor who decided to place his or her entire hedge-fund allocation in one of those to the far left of the chart would likely become disappointed.

Costs, too, may present a challenge for the average investor. Should an investor pick his or her own funds, or pay for someone else to choose? To self-select successfully means having a depth of resource, knowledge and understanding that’s not readily available to many investors. Paying someone else can come with additional, expensive costs. However, either option can be costly because resources, whether they are internal or external, must be paid for. This begs the question of whether the returns produced can justify the expense of generating them.

Finally, we must consider the issue of timing. The variation and complexity within the hedge-fund sector can, in itself, cause hesitation and lead to missed opportunities. Often, individual investors are simply not quick enough off the mark.

Why turn to passives?

Over time, investors have become more attuned to the potential pitfalls of active hedge-fund investing on a small scale. It’s unsurprising, therefore, that demand for lower-cost hedge-fund exposure has increased in parallel to their awareness. Initially, fund managers responded to this demand with "replicator" funds. These provide investors with an estimated exposure to the hedge fund universe using liquid proxies. Replication, however, involves using backward-looking techniques and creates high tracking errors. Sometimes, returns are closer to those produced by traditional asset classes. In essence, the profile that replicators offer is not always representative of the hedge funds they try to replicate.

Passive benchmark tracking offers a potential solution to these problems. It operates in a similar way to the funds that track traditional-market benchmarks, such as equity indices. This is to say, it invests in each of the underlying constituents of an index. Such an approach is possible because index providers, having identified the demand, have begun to create hedge fund benchmarks that are fully investable and replicable. Until recently, none existed.

Such indices offer investors a way of seeking to mimic the hedge fund market accurately. What was once possible only for passive investors in equities and bonds has become an option for those who want exposure to hedge funds. Passive hedge-fund investing, in contrast to replication, is forward-looking. At any particular time, it will give exposure to the current positions in the underlying hedge funds.

While some commentators are dismissive about passive investing, arguing that passive investors forego the chance to generate "alpha," passive hedge-fund strategies are different. Their underlying holdings are active hedge funds, as opposed to the equities that make up equity-tracker funds. Therefore, while fund-selection alpha is not possible, the underlying funds as a whole can generate alpha. At the same time, they can access the other benefits of hedge-fund investing. Among these are diversification opportunities and scope for risk reduction.

Passive investing also harmonizes interests. It can match those of the investor with those of the tracker, and, importantly, those of the underlying hedge-fund managers. This characteristic is notably absent from the replication process, which side-steps the hedge fund managers to avoid paying their fees. So, aligning the interests means managers of constituent funds might make their pricing more attractive for flows coming from passive vehicles. Consequently, the returns of the tracker product should be closer to those of the benchmark.

We should be clear that passive hedge-fund strategies will not entirely replace active fund selection. Instead, investors can view them as an additional tool to use when allocating their alternatives exposure. Some may see merit in using them for core allocations in portfolios, as with equity trackers. Others may use them for cash management. What is clear is that physically replicated hedge-fund-index trackers are a material leap forward in the evolution of alternative investing. We believe early adopters can potentially reap the benefits both of using this fledgling investment tool and helping to shape its future.

IMPORTANT INFORMATION

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Hedge funds use sophisticated investment strategies that may increase investment risk in your portfolio.  Among the risks presented by hedge fund investments are: the use of unregistered investments, which may make it difficult to assess the performance of the holding; risky investment strategies, which may result in significant losses; illiquid investments that may be subject to restrictions on transferability and resale; and adverse tax consequences.

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