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February 3rd, 2011 by

Hedge Fund Replication

Hedge funds are sexy, hedge funds get all the news, the good, the good, the bad and the ugly. Whether we like to admit to it, we want a piece of the action, we want to be part of it.

So finally the answer is supposedly here, for us poor retail investors. We now don’t have to be a High Net Worth individual with minimum wealth criteria to be a part of that hedge fund world, we now simply can buy a readily available retail product in a form of a mutual fund or an ETF that “replicates” hedge fund returns. Granted we are still many arms away from rubbing shoulders with those rich and smart hedge fund managers, but at the very least we can make the same kind of returns as they do.

So is this good or bad or the ugly? Well the short answer is: depends. The long answer: see below.

The short answers depends, well it depends on who you ask. The people who like hedge fund replication strategies will tell you about the access to inaccessible strategies, transparency of holdings, the liquidity without lockups, high returns and low fees. The people who don’t like it will tell you about lack of transparency (what?), low returns (huh?) and high fees (again?). Who do you believe then?

Well, I say, don’t be afraid and just read the ingredients.

I think that when companies like IndexIQ, or AdvisorShares or any company that gives us an actively managed fund, they actually bring value to the table. The fact of the matter is that we simply do not have access to a good hedge fund manager, in fact we don’t have access to any hedge fund manager due to accredited investor requirement by the SEC. So anytime someone gives us a choice, that is good.

If you look at the IndexIQ funds QAI, MCRO and MNA, they actually created ETFs that track Multi-Strategy, Macro and Merger Arbitrage hedge fund indices, respectively.  What Advisor Shares has done, they brought us hedge fund managers with their own individual strengths and strategies, they allowed us to access and invest with Harry S. Dent Jr. (DENT),  Mars Hill Partners (GRV), Mebane T. Faber (GTAA) and Ranger Alternative Management (HDGE ).

Let’s look at the pros for these investment vehicles. 1) they do provide access to strategies and managers that we would normally not be able to buy into, 2) they provide transparency (like all ETFs) with daily end of the day holdings posted on the web, 3) they provide liquidity without any type of lockups, 4) they provide returns based on their respective active strategy (it all depends on the benchmark), and 5) they charge management fee only, no performance fee like hedge funds do (i.e. 15-20% of the profits).

Let’s look at the cons. First, the transparency is not there, what they refer to is that the portfolio manager actively manages the fund and you don’t know what is behind his/her analysis, nor you will ever know. Well there is nothing wrong with that, because you either believe what the manager does or you simply pull your money out.

Second, low returns, which is true if you look at the most recent performance of some of these vehicles, but again you have to compare apples to apples. The IndexIQ’s MNA fund performed poorly, but so did a typical Merger Arbitrage hedge fund. Or look at Advisor Shares GRV, which except for the last month, had flat returns. Once again you have to recognize that GRV is an absolute return strategy, which during prolonged bull runs will underperform. What I really would like to see is what would happen with GRV in the down or flat market – somebody remember this conversation and we can talk then. On the other hand look at GTAA, it’s goal is to outperform S&P 500 and guess what, it did, rather nicely I would say.

The third, is that the fees that managers charge are high. Well that is only compared to passive, index following ETFs, which can charge anywhere from 20 bps (.2%) to over 100 bps (or 1%). So when a manager for a hedge fund replication strategy or an active ETF manager charges 1.50% or slightly higher, lots of cries are let out on how expensive it is. Well that is simply not true. You get what you pay for and for an active managed fund, assuming the manager performs, you better pay up. For example, the new dedicated short active ETF HDGE that just came out, charges 1.50% and some feel that is high. I beg to differ, because you have to ask yourself the following two questions. How easy it is to make money shorting? How many dedicated short fund are out there for you to choose from?

As I said earlier, don’t be afraid, pick wisely and read the ingredients.

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