By JOE LIGHT Contributed to WSJ
Hedge funds had a two-decade run as the investment of choice for wealthy investors. But lackluster performance since the financial crisis and high fees are prompting some investors to roll up their sleeves and build their own.
Since the market bottom in March 2009, hedge funds have gained 33%, according to indexer Hedge Fund Research, compared with a 110% rise for the Standard & Poor’s 500-stock index. In the past year, hedge funds have risen 4%, versus 15% for the S&P 500.
Gary LockeThe first step is to understand the forces that drive hedge-fund performance.
Some money managers and academics think they can do just as well on their own—at a fraction of the cost. The trick is to understand how hedge funds make their money, and then to mimic the recipes using cheap ingredients.
Just this year, money managers have launched 15 “multialternative” funds, so named because they use several different hedge-fund strategies, according to fund tracker Morningstar MORN -1.09% . That brings the total number of funds in the category to 81, and together they have attracted $3.3 billion this year.
Researchers, meanwhile, say there are ways for investors to build their own hedge fund-like portfolios from scratch. By using just a few low-cost exchange-traded funds, they can come close to replicating aspects of hedge funds’ performance, without the restrictions on withdrawals that many hedge funds have.
“If you want, you can re-create hedge funds in a low-cost way,” says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.
Hedge funds are known for taking outsize bets that can lead to big winnings—or huge losses. A hedge fund run by John Paulson of Paulson & Co. had gains of as much as 590% in 2007 thanks to a wager against the subprime mortgage market. But another Paulson & Co. fund, Advantage Plus, lost more than half its value in 2011 after ill-fated bets on financials and gold.
Replication strategies try to avoid the ups and downs of individual hedge funds’ performance by shooting for the middle. Thus the strategies can present a trade-off: You enjoy lower costs and more safety, but you give up the chance of out-of-the-park results.
Then again, market-beating returns aren’t the only reason to consider hedge funds. Some investors seek diversification, while others want to reduce their portfolio’s volatility. Here is how to get those benefits at a lower price.
The Secret Sauce
The first step in creating a hedge-fund-like portfolio is to understand the forces that drive hedge fund performance.
While many hedge fund managers say they earn their keep by doing intensive research into companies’ prospects—picking, say, Coca-Cola KO +0.16% overPepsiCo PEP -0.07% because they think its marketing strategy is superior—research shows that most of hedge funds’ performance is determined by larger forces known as “risk factors”—common traits that many different kinds of investments share.
The concept is analogous to diet: People can get the same basic nutrients from a variety of foods. Vitamin C, for example, can be found in oranges or Brussels sprouts; iron, in beef or pumpkin.
Similarly, researchers have broken down hedge funds into their underlying nutrients. Different combinations of these nutrients can produce different investment results.
The first widely accepted nutrient—”beta”—simply describes how a stock or mutual fund moves in relation to the overall market. For example, according to FactSet,FDS -0.05% Apple has a beta of 1.21, meaning when the S&P 500 rises 1%, Apple’s stock tends to rise 1.21%.
Other risk factors include size (small market capitalization or large market cap), style (value or growth) and momentum. Dozens of others are less agreed upon, from exposure to various currencies to sensitivity to gross-domestic product.
All told, up to 80% of the average hedge fund’s returns can be explained simply by size, style and market beta, according to an analysis conducted for The Wall Street Journal by Mr. Bernstein.
For example, hedge funds as a group have had a beta of about 0.39 to the Russell 3000 index of U.S. stocks over the past five years, meaning they tend to rise 0.39% for every 1% increase. That, together with a negligible turn toward large-cap stocks rather than small, and a stronger move toward growth stocks rather than value, can explain most of hedge funds’ performance, according to Mr. Bernstein’s analysis.
Despite their common attributes, hedge funds charge a princely fee for their services—typically 2% of assets and 20% of any profits. Many also require big initial investments—often $250,000 to $1 million—and require the money to stay put for a certain period, typically a year or longer.
How to Copy Them
Once you know what hedge funds are made of, you can look for ways to get the same basic nutrients at a lower cost.
According to Mr. Bernstein’s analysis, investors can more or less replicate hedge funds with just a handful of low-cost ETFs containing the same essential nutrients—market beta, size and style.
The building blocks are simple: varying amounts of just two ETFs, plus cash. One ETF tracks the Russell 3000 index, which includes 98% of the U.S. stock market. The other includes the Russell 3000’s “growth stocks”—companies with high prices relative to their “book value,” or the total value of their assets minus debts.
For example, Mr. Bernstein found that to get the same nutrients as an average hedge fund, investors can use a portfolio with 21% in the iShares Russell 3000 Growth Index ETF, which has a 0.25% expense ratio, 18% in the Vanguard Russell 3000 ETF, which charges 0.16%, and the remainder in cash. Over the past two years, the portfolio would have returned 4.5% annually, versus 1% for the HFR composite index, after fees.
There are four broad categories of hedge funds. They have the same nutrients—just in different proportions.
“Equity-hedge” funds. These funds buy stocks they believe in while betting against companies whose shares they think will drop. For them, beta, size and style explain more than 86% of equity hedge funds’ performance, according to Mr. Bernstein.
To mimic the typical equity fund, you could use a portfolio with 38% in the growth ETF, 16% in the Russell 3000 ETF, and 46% in cash, Mr. Bernstein says. Such a portfolio would have returned 6.3% annually over the past two years, versus 0% after fees for the HFR Equity Hedge index, an index of equity hedge funds.
“Relative-value” funds. Such funds wager on the price differences between related investments. To replicate the average relative-value index, investors could put 14% in the growth ETF, 15% in the total market ETF, and 71% in cash. Over the last two years, that portfolio would have returned 3.3% annually after fees, versus 4.9% after fees for the HFR Relative Value index, which tracks relative-value funds.
“Event-driven” funds. These funds seek to profit from special situations, like big news events, mergers and takeovers. They can be replicated with a portfolio of 14% in the growth ETF, 24% in the total market ETF and 62% in cash. Such a portfolio would have returned 4.3% annually after fees, versus 4.9% annually for the HFR Event-Driven index, which tracks those funds.
“Macro” funds. The fourth broad category of portfolio, macro funds can rapidly change their exposure to asset classes and countries based on macroeconomic factors. They are almost impossible to mimic with a passive ETF portfolio. Very little of macro hedge funds’ performance over the last five years can be explained by beta, size and style, according to Mr. Bernstein’s analysis.
Some hedge-fund performance is influenced by other factors to varying degrees, like interest-rate movements and currency fluctuations. Funds that deliberately jump around over time can’t be easily mimicked with a passive portfolio. There also is the threat that hedge funds change their factor exposure after you have built the portfolio.
That means every year or so, it might pay to do a new analysis to see how hedge funds’ portfolios have changed. Mr. Bernstein has a guide on his website atefficientfrontier.com/ef/101/roll101.htm, but the process is difficult. A financial adviser should be able to run the same analysis for you.
What’s more, by simply tracking indexes, you won’t see the kind of remarkable gains or losses that get hedge-fund managers mentioned in newspapers, notes Andrew Lo, a professor at the Massachusetts Institute of Technology who founded AlphaSimplex Group, which manages its own, more complicated, hedge-fund-replication strategies.
Then again, “even if there are talented managers, how do you know who they are?” Mr. Lo says.
A growing number of money managers have rolled out mutual funds and ETFs that use similar approaches with more sophisticated tools.
AlphaSimplex Group, for example, runs mutual funds that try to provide hedge fund-like performance by using futures contracts. For example, the Natixis ASG Global Alternatives Fund, which AlphaSimplex runs, manages $1.2 billion. It has a 1.6% expense ratio, or $160 per $10,000 invested—quite high compared with many mutual funds but much lower than hedge funds’ customary 2% annual fee and 20% performance fee. The fund has returned 2.4% this year, and 2% annually over the past three.
Rye Brook, N.Y.-based IndexIQ, which manages just under $1 billion, has a suite of ETFs and a mutual fund that track hedge fund strategies by changing factor exposures over time. The IQ Alpha Hedge Strategy Fund, which costs 1.92%, seeks to replicate a broad hedge-fund index and is rated “bronze,” by Morningstar, the company’s third-highest rating.
The fund has had a total return of 3.7% year-to-date and has returned about 1.5% annually over the last three years. CEO Adam Patti says the firm has seen increasing interest from institutional investors lately.
The AQR Multi-Strategy Alternative Fund, which costs 2.23% annually, doesn’t try to replicate a hedge-fund index. Instead, it seeks to identify the economic drivers behind hedge-fund performance and build a portfolio that takes advantage of them. This year, the fund has returned 1.75%. The fund has a high investment minimum of $1 million but is also available at a lower minimum through financial advisers.
Other funds try to mimic only what they think are the best hedge funds. Ramius Alternative Solutions, a unit of Cowen Group, for example, manages about $800 million in strategies that replicate portfolios of funds Ramius thinks will perform best in the future. Its Dynamic Replication Fund, which launched in 2010, charges 1.93% annually and has been about flat this year.
Says Vikas Kapoor, co-head of Ramius Alternative Solutions: “If you replicate a bad portfolio, even if you do it well, there will be a bad outcome.”