Hedge funds have long held a mystique for financial advisors looking to invest in uncorrelated asset classes. Despite the allure and potential high returns of hedge funds, their high fees, limited liquidity and extremely high minimum investments have deterred most advisors from integrating them into clients’ portfolios.
Subsequent to the financial crisis of 2008, a growing number of mutual funds employing alternative strategies have hit the scene and been warmly received by both investors and financial advisors seeking protection against seemingly chronic volatility in the financial markets. Among them are funds designed to mimic hedge funds by striving to deliver absolute returns while charging less than a hedge fund’s typical 2 and 20 fee (a 2 percent management fee and 20 percent of any profits).
Morningstar tracks three such funds as a subset of its overall multialternatives category. Hedge fund replicators are built on the research of Andrew Lo, an MIT finance professor and portfolio manager. These funds attempt to figure out what strategies hedge funds are using by analyzing correlations between hedge fund indices and stocks, bonds and other asset classes.
Lo and other researchers argue that hedge funds offer alternative betas to traditional stock and bond indices, and take on different kinds of risk such as shorting put options or international bonds. By analyzing the returns and correlations, they can then try to duplicate these exposures and track the returns of an appropriate hedge fund index.
Only As Good As The Underlying Index
While hedge fund replicator funds generally have tracked their index well, the problem is that index has tracked an investment category that in recent years has by and large produced underwhelming performance numbers.
The Goldman Sachs Absolute Return Tracker fund (GARTX), for example, has an expense ratio of 1.55% and a 3-year average return of 1.09 percent. It has accurately tracked the HFRI Fund Weighted Composite Index with a correlation of 91 percent over the life of the fund. The Natixis ASG Global Alternatives fund (GAFAX.lw), which charges an expense ratio of 1.61 percent and has returned 3.31 percent over the past 3 years, has an 82 percent correlation to the same index.
Despite the puny returns, some advisors have been satisfied with these funds. “There was no good liquid alternative to hedge fund of funds before replication strategies became available,” says Mark Wilson, chief investment officer at The Tarbox Group in Newport Beach CA. “We decided on the Natixis fund because Andrew Lo, whose research underlies the fund, is the portfolio manager, and we liked their risk control process and target volatility of 9 percent.” (In 2007, Natixis Global Asset Management bought Lo’s investment firm, AlphaSimplex Group LLC.)
Wilson acknowledges the fund has underperformed the broader equity markets, but sees opportunities ahead. “The fund has outperformed its index by 1 percent a year, delivering reasonable volatility and index outperformance,” he says. “If the S&P runs into some difficulties, we think the relative performance will be better.” He notes that stock correlations are higher than normal, and any decline would make a replication strategy more appealing by potentially improving hedge fund index returns.
Morningstar rates the Goldman Sachs Absolute Return Tracker fund as "negative" and the Natixis ASG Global Alternatives fund as “neutral.” Morningstar analyst Josh Charney calls into question how much proveribal bang for the buck investors are getting considering these funds charge fees akin to actively managed funds while touting their goal is just to match an index.