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

Background

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 HedgeFundReplication.com'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.
LowCostHedgeFunds.com
IndexedHedgeFunds.com
PassiveHedgeFunds.com

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."

Articles

• Pensions and Investments
  • Merger arbitrage hedge funds beat LIBOR (10/19/2010)
  • September 2010 Hedge Fund Returns (10/14/2010)
  • Moving from funds of funds to direct hedge funds (7/15/2010)
  • Hedge Funds returns 2Q10 (7/14/2010)
  • Hedge funds of funds not so Sharpe (4/21/2010)
• CNBC
  • How To Build A Poor Man's Hedge Fund (10/18/10) - Michael Livian says “Most hedge funds should be out of business.”
  • Hedge Fund Managers Set Up for Next Acts (9/17/2010) - After shutting his giant fund following a humbling loss, Mr. Pallotta, the money manager who is an owner of the Boston Celtics, is doing what hedge fund types do in tough times: he is opening a new fund.
• Hedge Funds For The Rest of Us from IndexUniverse (July/August 2007) - In 2006 alone nine funds over $1 billion closed their doors.

Research

• The Secondary Market for Hedge Funds and the Closed Hedge Fund Premium from Tarun Ramadorai (Forthcoming Journal of Finance)
• Predicting Hedge Fund Failure: A Comparison of Risk Measures (Summary) by Bing Liang and Hyuna Park - "The authors demonstrate that downside risk measures are more effective in predicting hedge fund failures than traditional risk measures. They also highlight that the attrition rate for hedge funds does not necessarily reflect failure; on an annual basis during 1995–2004, the real failure rate was lower than the attrition rate." (August 2010)
• Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution (July 5, 2007 version) by Nicolas Bollen and Veronika Pool in The Journal of Finance (October 2009)
• Hedging Real Estate Risk from Frank Fabozzi, Robert Shiller, Radu Tunaru in The Journal of Portfolio Management (September 2009)
• How Smart are the Smart Guys? A Unique View from Hedge Fund Stock Holdings by John M. Griffin and Jin Xu in The Review of Financial Studies (July 2009) - "The sector timing ability and average style choices of hedge funds are no better than that of mutual funds. Additionally, we fail to find differential ability between hedge funds. Overall, our study raises serious questions about the proficiency of hedge fund managers."
• The A,B,Cs of Hedge Funds: Alphas, Betas, and Costs from Roger G. Ibbotson and Peng Chen (September 2006) - "Our results indicate that both survivorship and backfill biases are potentially serious problems."
• Hedge Funds: Risk and Return from Burton G. Malkiel and Atanu Saha
• A Reality Check on Hedge Funds Returns by Nolke Posthuma and Pieter Jelle Van der Sluis (July 2003)
• 10 Things That Investors Should Know About Hedge Funds in The Journal of Wealth Management (Spring 2003) frm Harry M . Kat (also)
• Hedge fund survival lifetimes from G N Gregoriou Journal of Asset Management (2002) - median residual lifetime 5.5 years (also)
• Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value? from Harry M. Kat and Gaurav S. Amin (May 2001) - "monthly returns of 77 hedge funds and 13 hedge fund indices over the period May 1990-April 2000. The results show that as a stand-alone investment hedge funds do not offer a superior risk-return profile."
• Offshore Hedge Funds: Survival & Performance 1989-1995 from William N. Goetzmann, Roger G. Ibbotson, and Stephen J. Brown - "The industry is characterized by high attrition rates of funds, low covariance with the U.S. stock market, evidence consistent with positive risk-adjusted returns over the time, but little evidence of differential manager skill."

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