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The New Challenge for Hedge Funds

ETFs take aim.

John Rekenthaler, 12/06/2013

Cyber Manager
Hedge funds exited 2008 with their reputations in tatters. Terrific relative performance during the 2000-02 technology sell-off, followed by solid gains during the next few years' stock-market recovery, had stoked expectations to unrealistic levels. Many thought that hedge funds could consistently avoid stock-market slides. In 2008, they could not. The result: recriminations, bad press, and investor redemptions.

(The recriminations have long since ceased, and sales are now modestly positive, but public standing remains a problem. So much so, in fact, that according to a paywalled article in Barron's, a judge ruled in SAC Capital's case that it would be prejudicial to state that the defendant runs a "hedge fund." Instead, the official description used by the court is that SAC Capital runs "a fund.")

Now comes a new challenge: So-called "guru" exchange-traded funds, which seek through rules-based investment systems to mimic the portfolios of successful hedge fund managers, while offering ETFs' advantages of liquidity, transparency, and low costs. Naturally, these rules-based ETFs cannot fully duplicate the managers' holdings, but perhaps they can get close--enough so that their cost advantages enable them to match or even exceed the net returns of the original hedge funds.

Sound silly? Before pooh-poohing the idea, it's worth noting that AQR's Cliff Asness--nobody's fool and a hedge fund manager himself--has opted for a similar path. Years ago, Asness noted that much of what is labeled as "alpha" with hedge funds, that is the contribution that owes to the fund manager rather than to market behavior, was really not alpha. Not in the sense of being unique to that person. That alpha owed instead to a strategy--perhaps buying stocks with high price momentum, or perhaps the merger-arbitrage approach of buying the stock of a company targeted in an acquisition while simultaneously shorting the stock of the acquisitor.

As a result, AQR has launched several strategy mutual funds. They are not quite the same thing as guru ETFs, as strategy funds mimic an investment approach, while guru ETFs look instead at the investment holdings of leading managers, but the general concept is similar. When creating the liquid, low-cost alternative, don't worry about being exact. Getting the general idea right is sufficient. If the ETF can stay in sight of the gross returns of the hedge funds, its cost advantage will finish the job.  

Felix Salmon, for one, has kind words to say about guru funds. In Why Guru ETFs Beat Human Gurus, Salmon writes:

"It's easy to laugh at these things--13F filings, for instance, are lagging indicators that don't give any indication of how hedged an investor is, or whether [he's] putting on some kind of relative-value trade, or what [his] exit strategy might be. But never mind all that: iBillionaire has lots of pretty charts showing consistent outperformance over various time periods from one month to eight years."

Yes, Salmon grants, that past outperformance is sleight of hand, because the ETF was permitted to create its index in hindsight. It won't have that luxury going forward. But, Salmon adds:

is vice president of research for Morningstar.

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