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Hedge Funds, Hedge Fund Replication, and Individual Investors

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Gary Karz, CFA (email)
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Founder of low-cost investment advisory firm Proficient Investment Management, LLC


     The evolution of index funds and ETFs have provided investors the opportunity to buy diversified, low-cost exposures to traditional asset classes like stocks, bonds, and real estate (including in foreign and emerging markets). Yet $billions have flowed into hedge funds in the last decade that are generally less transparent, less accessible, and tend to have much higher costs than traditional funds. Many large institutional and high net wort investors allocate significant percentages of their portfolios to hedge funds and other alternative asset classes.

     A logical theory is it should be possible to create index-like hedge funds that simply create diversified exposures to the same investments that hedge funds create (or use simple rules to create the funds), with relatively low costs. There are plenty of smart people that have started doing just that, or are implementing similar strategies.

     "Hedge Fund Replication" is an approach that has been developing in the institutional world in recent years. For individual investors, an interesting option is being pursued by IndexIQ, which has several ETF's that intend to replicate hedge funds at lower costs, and without the lock-up and liquidity issues. Building assets and a strong track record appear to be part of IndexIQ's initial challenge.

     More background on the topic can be found at's Research list, which includes Hedge Fund Replication: A Revolution In The Making? discussing State Street Global Advisors information and Hedge Fund Returns: You Can Make Them Yourself! (which summarizes that ..."it is possible to generate returns that are statistically very similar to the returns generated by hedge funds but without any of the usual drawbacks surrounding alternative investments").

     Democratizing Alternatives Real-World Hedge Fund Replication from IndexIQ summarizes that "Hedge fund replication strategies promise to deliver the powerful investment characteristics of hedge funds at a much lower cost and with additional liquidity and transparency. They also deliver these benefits without the idiosyncratic risk of individual hedge fund investing." See also this white paper (which discusses the efficient market hypothesis and fundamental indexing), an Interview with Adam Patti of IndexIQ by USNews and 'Hedge Funds' for Everyone from BusinessWeek.

     Since it still seems early in this industry's development and it's so cheap to grab domain names, I went ahead and checked a few domains that I'd consider logical virtual locations for an idea like this. I found some I think could be great web sites for a venture of this sort. So I took these.

     Even though plenty of others have already been developing businesses along these lines, history is littered with examples of first movers that were later dominated by second or later players who executed better strategies.

     Do Hedge Funds make sense for individual investors? Personally, I don't have much hedge fund experience and am not sold on the general hedge fund proposition (nor do I recommend them to my clients). I recognize there are some very skilled hedge fund managers and if you can generate competitive returns with low correlations to traditional long-term investments, hedge funds in some specific asset classes can make sense as part of an efficient portfolio. Plenty of top academics have studied and written about hedge funds (see below) and for me, aside from the often high costs, other sticking points include the lack of transparency as well as survivorship and other performance biases. I still find it hard to believe that Long Term Capital Management's final month of performance wasn't included in any of the hedge fund universes, which is indicative of one of the major problems with hedge fund performance reporting.

     Speaking of hedge fund universes, there are many. Pensions and Investments reported on September 2010 Hedge Fund Returns recently. They included indexes from Barclays, Hennessee, Eurekahedge, HFRI, Dow Jones Credit Suisse, Greenwich, Newedge CTA, plus fund of fund indexes from HFRI and Eurekahedge. Other sources include the TASS Database, CSFB/Tremont, and Van Hedge Advisors.

     Some examples of relatively low cost hedge fund sponsors with arguably higher probabilities of success include AQR (which has an extensive online library) and Singer Partners, where you can read You Get What You Pay For, And Sometimes More: A Cautionary Note for Investors, which states "The bottom line is that hedgefund database returns provide estimates of hedge fund performance that range from 500 bps to over 1,000 bps above the performance that hedge fund investors actually receive."



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