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Hedge Fund Strategies Without the Hedge Fund

Jason Stipp

Jason Stipp: I'm Jason Stipp with Morningstar. We're visiting Goldman Sachs Asset Management in New York today, and we're going to talk about hedge fund replication with Theodore Enders. He is the vice-president and portfolio strategist for the Portfolio Strategy Group here at Goldman Sachs Asset Management.

Thanks so much for joining me, Theodore.

Theodore Enders: Thank you, Jason.

Stipp: Before we talk about the specific product that you folks have to offer, I just want to talk a little bit about hedge fund replication and alternative strategies and what the allure is for investors. Why would someone want to pursue this kind of an approach in their portfolio?

Enders: We find the attractiveness of alternative strategies to come really from the role of risk reduction in a client's portfolio, and risk reduction in an efficient way. If you think about the asset class of alternative investments, mostly hedge funds, they tend to have much lower volatility or risk than equities do, and they tend to be very efficient at converting that risk into returns.

When you incorporate strategies like that in a portfolio that has very beneficial efforts on the portfolio as a whole.

Historically people have had to turn to hedge funds with some very complicating characteristics associated with them in order to get that risk reduction and that volatility reduction and returns improvement. But with hedge fund replication, there are opportunities to get the same benefits without a lot of the drawbacks.

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Stipp: How exactly then does that replication work? A lot of hedge funds use some rather exotic instruments to accomplish what they are trying to accomplish. What does it mean to try to replicate something that is seemingly so complex?

Enders: Hedge fund replication relies on an interesting characteristic of the asset class of hedge funds. Most people think of hedge funds as being predominantly comprised of alphas. But when you look at the industry as a whole, that turns out not to be the case. Most of hedge fund returns come not from alpha or security selection, but from betas, broad exposures to market indices long and short.

People also think of hedge funds as a group as being very tactical, that they quickly move their exposures from one area to the other, like into tech stocks or into cash. That's not really the case, either. They tend to move their overall exposures very gradually over time.

Well, if you put those two things together, that hedge funds aggregate exposures move slowly and that most of their returns comes from these broad market exposures, then if you can identify those broad market exposures, you can own those in a portfolio and have that portfolio behave a great deal like the hedge funds themselves.

And that's the concept of hedge fund replication. Goldman Sachs Absolute Return Tracker Index is the Goldman Sachs technique of hedge fund replication, and the Goldman Sachs Absolute Return Tracker Fund is the way of implementing the Goldman Sachs Absolute Return Tracker Index.

Stipp: As with any strategy that's trying to track or replicate an index or some sort of universe, there's always the possibility of tracking error. So how closely has this fund been able to replicate and to have the performance that you expected it to have?

Enders: There are really three things to keep in mind here. There are the returns of the actual hedge fund industry that we're trying to replicate. There are the returns of the Absolute Return Tracker Index. And then there are the returns of the Absolute Return Tracker Fund.

All these things work very well, but the Absolute Return Tracker Index we expect to lag the actual hedge fund industry by approximately 2% over reasonably long time frames, due to some alpha that exists in actual hedge funds that is not part of what we can provide in the Absolute Return Tracker process.

But in exchange for that slight lag, or slight underperformance, daily liquidity is very attractive component of a strategy like this. The fund itself tracks the GS-ART index very closely, 40 to 60 basis points of tracking error over time.

Stipp: And thinking from a portfolio management perspective, you mentioned risk before. But if I'm relatively balanced in my portfolio, how should I think about incorporating this into an asset allocation plan that's got some bonds, some stocks? How much of a position should this occupy?

Enders: There are lots and lots of ways to think about implementing alternatives in a portfolio. Since the objective is really to reduce risk, we think the most logical way to think about it is to fund an allocation to alternatives, or the Absolute Return Tracker Fund, out of the riskiest portion of a portfolio, and in most cases that's equities.

So without knowing anything specific about a client we generally recommend about a 10% allocation to the Absolute Return Tracker process, funded from equities. And when we think about a it really more broadly, we tend to think of the typical client's risk profile as coming from about 40% of an allocation to equities, 30% an allocation to fixed income, 20% an allocation to diversifying asset classes--what we call satellites like emerging markets equity and commodities, long only investments there. And then 10% to alternatives. So 40-30-20-10 or a 4-3-2-1 portfolio.

Stipp: Theodore, thanks so much for your insights and for explaining this process to us. We really appreciate your time.

Enders: It's my pleasure, Jason. Thank you for having us.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.