Hedge Funds and ETFs

Hedge funds charge hefty fees. Because they are that good (or so they claim)! They seem to provide good returns that have little in common with the overall stock market return (S&P 500), or U.S. bond market returns. But what is the source of their returns? Is it a stream of new and ever ingenious investment ideas generated by the hard work of a hedge fund manager, or could it be some “secret formula”, discovered long ago, and run by a computer, while the hedge fund manager is now busy golfing and fishing? An example of such a strategy would be just writing out-of-the-money put options on the S&P 500 index.

I, personally, have nothing against paying high fees for truly new investment ideas, generating high returns. For example, SAC’s 50% performance fee sounds like a fair deal for “sure-thing” returns generated by insider tips (oh, if only that strategy was legal)… On the other hand, I do have a problem paying a 20% performance fee as a “royalty” to a computer running a formula discovered a long time ago. However, if nobody else on the market offers returns based on the same (or similar) formula, then I am stuck with that hedge fund. And that is exactly what the situation was until recently.

So what changed? The short answer is that it is the number of exchange traded funds (ETFs) available! In essence, ETFs are exchange traded portfolios that are automatically run at a very low cost to investors. ETFs are liquid, the formulas for their portfolio composition are completely transparent, and there are no excessive “royalties” for access to their formulas! And the number of available investment strategies (i.e. “formulas”) has grown tremendously since the first ETF became available in 1993. For example, there were 19 U.S. listed ETFs in 1997, and there are thousands of ETFs available now, providing access to a great variety of strategies that were previously available only to hedge funds (writing out-of-the-money put options included). In a way, one may think of ETFs as a giant collection of readily available investment strategies, which can be easily put together.

It turns out that for great many hedge funds, it is possible to replicate (or “clone”) their “secret strategy” using available ETFs as LEGO building blocks (see my paper with Jun Duanmu and Eddy Li here)! Our approach exposes hedge funds that earn money by simply riding some obscure risk factor (and we can easily sniff that out, and successfully clone these funds).

On the other hand, we can’t clone hedge funds with truly innovative strategies, and these funds seem to be quite good as a group (we call them “non-cloneable”), but they do have a tendency to die at a higher rate than “cloneable” funds. Alas, there is no “free lunch” here as well…

In the end, there are two big alternatives for anyone who thinks of investing in hedge funds. If you think about investing in “cloneable” hedge funds, don’t do it, as you can do better with ETF clone portfolios. Or you can roll the dice of investing in “non-cloneable” funds, but be aware than these hedge funds are more likely to die on you. Ultimately, the choice is yours…