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Replicating Hedge Fund Returns With ETFs

Scott Burns

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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Hill: Right. That's a big benefit here because the HFRI Index as you said does reflect the different assets of the industry, like for example in the late '90s, it was very much into technology. Long/short, now macro and managed futures are a bigger part of it. So that gets captured in this HFRI Index, and therefore, indirectly, in the Merrill Lynch Factor Model, which is looking for a high correlation to that. So that makes it quite different from let's say a mutual fund that invest in a smaller set of hedge funds.

Burns: Over time when we look at that kind of flow, given that hedge funds are reserved for institutions, people with a lot of money--presumably people who are putting a lot of resources into their investment management and their allocation decisions, really I think is what it comes down to--are we looking at smart money or is smart money just as prone as the same problems as retail money in terms of chasing returns, et cetera.

Hill: Well, I think it's smarter money. Because the hedge fund managers are compensated fairly well, if you look at the fee structure for looking at the investment opportunity set. So the benefit is that they do tend to be early and they tend to be more right perhaps than some of the other active managers. People say it attracts the best and brightest of investors.

But I think the benefit of replication strategy is that it can overcome some of the challenges that people might have of trying to capture that with direct hedge fund investing. This is especially true that if you have a smaller amount of money to invest, you have only maybe 10%-20% allocated to alternatives and you want to have just a few holdings, especially one that captures hedge-fund-like returns. That's why we think an ETF vehicle can be quite attractive in this category.

Burns: So, another interesting thing when I look the fund, in particular, is that there are lot of securities in there. There are also some swaps. I think when we look at other hedge-fund-strategy ETFs, we see other ETFs; when we think about funds of funds, we see other funds. So, why did you choose to go that route with this particular vehicle?

Hill: Well, I think that the hedge-fund-replication strategies are based on these market factors, and so we're looking for the most cost-efficient and most liquid way of achieving those factors. And in some cases that's futures. It could be direct portfolios for S&P 500; it could be swaps. And these factors can be held either long or short, and so in many cases derivatives are the most efficient way, especially in getting the short exposure.

And certainly what hedge funds do differently than many traditional managers is use leverage and shorting in their strategies. So, it makes sense that this would be a part of hedge fund replication.

Burns: So, I think lot of people when they see all of those holdings--because it looks like the whole S&P 500 is in there and everything--they will have questions. Doesn't that make the transaction costs more expensive and things like that? How do you respond to that?

Hill: Right, well this is a mutual fund, so we do want to have a certain amount of securities in there. And so if you look at a portfolio trade in the S&P 500, holding all the constituents, you'll see that that can be done very cost effectively. It's part of any basic S&P 500 index fund. So, we can use it in a cost-efficient way in our strategy, as well. But we're always looking to see should we be using futures, forwards, or swaps.

Burns: I guess one last thing I want to discuss is just some nuts and bolts on the returns of the index. In terms of standard deviation, how does this match up with say U.S. equity-type risk?

Hill: Well, when most people look at hedge fund returns, they will look at the risks in terms of drawdowns, or they look at the Sharpe ratio, not just in terms of the risk. The benchmark for the fund is looking to track the HFRI. So, if you look at the volatility of the HFRI or the Merrill Lynch Factor Model, it tends to range between let say 4% and 8% or 9% in terms of volatility. And so it's definitely less risky than an equity exposure.

Burns: Right, because the S&P is still around 15%, still more or less, right?

Hill: Right. If you were to try to calculate a beta of these indexes to S&P, it would come out at about 0.3 or 0.4 or so.

Burns: So a real diversifier.

Hill: Definitely.

Burns: Well, Joanne, it sounds like a very interesting fund. Thanks for stopping by to talk about it.

Hill: Great. Well thank you. I appreciate the chance.

Burns: And for this and other ETF information, please check out's ETF Center and Morningstar's ETFInvestor newsletter.