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By Scott Burns | 08-01-2011 04:47 PM

Replicating Hedge Fund Returns With ETFs

By breaking down hedge fund returns into various factors, new ETFs can replicate returns at a lower cost and with greater liquidity, says ProShares' Joanne Hill.

Scott Burns: Taking a look at an ETF hedge fund replicator. Hi, there. I'm Scott Burns, Morningstar's director of exchange-traded fund, closed-end fund, and alternatives research.

Joining me today is Joanne Hill, head of investment strategy with ProShares. Joanne, thanks for joining me.

Joanne Hill: Great to be here.

Burns: So Joanne, ProShares recently launched the Hedge Replication ETF; the ticker on that is HDG. Let's talk about this fund a little bit. I think in the 40 Act space there is a growing number of these hedge fund multistrategy options out there. We have definitely seen a growing trend of the on-exchanging or on-transparency of a lot of these hedge fund strategies. What makes HDG a little different?

Hill: Well, I think that you can think of this as really something that is seeking to achieve the returns of a broad universe of hedge funds, almost like you would think of a broad passive index might be seeking the returns of an equity market. So, what we found was that hedge fund investing is a key component of alternatives, but yet there are so many challenges of direct hedge fund investing. And even in the mutual fund form, there is less liquidity, more limited access, higher fees, and lack of transparency.

And so, we felt that there was room for taking the ETF packaging and all the liquidity and transparency that it has to offer and trying to come up with a strategy that offered the risk/return features of a diversified hedge fund portfolio.

Burns: Right. So I think I mean it's very interesting. This is the passive version of a broad kind of hedge fund investment; would you say that that characterizes it correctly?

Hill: Yes, I would. I think that it is representative, though, of the dynamics of the hedge fund industry. 

Burns: How so?

Hill: It uses a process called hedge fund replication, and this is something that has been in the academic realm and well researched for more than a decade. But the idea here is that you can take a broad-based index like HFRI, which it really captures the performance statistics of about 95% of the assets of the hedge fund industry; it has 2000 hedge funds in it. So, when you look at that, you can actually reduce the returns and risk features into a set of six or more tradable factors. So what hedge fund replication seeks to do is capture these return and risk characteristics, but it does it in a way that you can move in and out, trade it, and see the factors. It makes it more accessible to a broader group of investors than available.

Burns: I think it's fascinating when you reduce those factors, and in some ways even maybe an indictment of the broader hedge fund industry, that what you are really looking at is, in a lot of times, a big pile of cash with some Russell 2000, S&P 500, or a broad international index. I mean is that what we have kind of seen over time?

Hill: Well, the benchmark for our fund is the Merrill Lynch Factor Model Exchange Series. So, you're right; it consists of the six factors in it. It's T-bill-based and then equity indexes that you might own now, S&P 500, Russell 2000, EAFE, a currency, and so on. But what changes over time is the weighting.

So, basically they use a quantitative technique to weight these factors, and this is how they come up with the, in effect, the secret sauce of what's going on in the broad universe of hedge funds, by changing the weights of the factors every month to capture the dynamics of the returns.

Burns: I think something that's interesting about this is that as money is kind of flowing into these different aspects of the hedge fund world--event-driven, emerging markets, the various I believe six kinds of aspects that the HFRI Index is tracking--this fund is kind of picking up those fund flows, right?

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