The New Challenge for Hedge Funds

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:

"… no matter how high the fees on these ETFs might go, they'll never come anything close to the kind of fees charged by Jason Ader [a hedge fund manager who serves as Salmon's foil] and his ilk. The ETFs just sit back and follow a predetermined strategy, rather than feeling the need to do the rounds of media organizations, spouting random 'conviction trades for the coming year.' Cheaper and quieter? It's a winning combination."

Clearly, that man has attended too many money-manager presentations.

Overall, I share Salmon's view. I'm not terribly excited about owning a mostly long-only version of a hedge fund (one of the guru funds can go partially short, but even there, it is shorting an index rather than individual stocks). That said, I'm in no rush to purchase a traditional hedge fund either. Of the two choices, the ETF seems to me more attractive. It can easily be traded, there's no danger of fraud, and its after-expenses performance likely will be competitive--if not superior--with that of the leading hedge funds.

It's not all bad news for the hedge fund business, though. Indirectly, guru funds validate the contributions of hedge fund managers. After all, if hedge funds had become a complete joke, as seemed possible in the industry's dark days of late 2008 and early 2009, these ETFs wouldn't exist. And to the extent that the guru ETFs succeed, they will call attention to their underlying investments. Guru ETFs don't compete with hedge funds; they complement them.

Two Bulls
Two bulls have their say on stock-market prospects.

First, investment manager Howard Marks maintains in Advisor Perspectives that "Equities are Under-owned and Un-loved." (I'm not sure what those hyphens are about.)

The argument is not as radical as the headline suggests. Marks believes that bonds have been overbought and are overvalued, that the marketplace is in the process of rotating to other assets, and that stocks will benefit from the rebalancing activity. Marks does not argue that stocks are cheap in absolute terms. Rather, he says, stocks are priced in the "upper part of the fair territory."

That could be. Underowned and unloved seems a bit much, but modestly pricey becoming more pricey is certainly possible. 

Second, Morningstar's Paul Justice emails:

"Am I the only bull in the pasture? The professional masses are saying all good news is really bad news. I'm not buying it. How are the unexpected rise (and previous revision) in private payrolls from ADP, surging auto sales, the biggest increase in new home sales in 33 years, and relatively low energy prices all going to converge to prove that we aren't finally realizing a fundamental recovery? Besides, wholesale inventories grew in line with forecasts."

No, Paul, you share the grass with Marks. And with Jeremy Siegel, as well. That makes three of you. 

Next week, the bears will talk. Several readers have emailed me links to money managers who have turned sour on the stock market. We'll look at why. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.