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Index provider challenges hedge fund performance


Tim Edwards, Senior Director, Index Investment Strategy at S&P Dow Jones Indices has investigated the news this week from ETFGI that ETF assets have overtaken hedge fund assets.

“It may have taken a little longer than we expected, but ETFs are now a bigger part of the market than hedge funds” Edwards writes.

“In order to explain why hedge funds might be losing out in the race for assets, we thought we would re-examine the challenge of replicating hedge fund performance.  When it comes to individual hedge funds, which are typically unconstrained by assets, leverage or geography, replication is a difficult objective.  When it comes to a broad hedge fund portfolio, replicating performance is easier than you might think.”
To begin the replication process, Edwards created a hedge fund that invested half its money in US bonds, and the remainder in global equities.  For the purposes of the experiment, he used the S&P U.S. Aggregate Bond index to represent the first portion and the S&P Global 1200 for the second.
From June 2010 to June 2015, the hedge fund would have mirrored the index but achieved higher returns, clocking in with 150 per cent return over the period, against the HFR Fund-Weighted Composite Index return of 130 per cent.
He writes: “The pattern of returns seems similar, which is encouraging.  And our decision to allocate to equities and bonds in equal proportions means that the overall return from our replication strategy is much higher.  Well done us!”
However, Edwards warns that congratulations are premature.  “Our replication strategy does not include costs, or fees.  The replication costs of broad-based, passive indices are de minimis, but we should not undervalue our unique insights (we are replicating a hedge fund, after all).  A fee of 1.50 per cent per annum seems reasonable, and we’ll take 15 per cent of any profits (provided we’re at least breaking even over the past 12 months).”
With these additions, performance in the created fund drops to pretty much matching the HFRI index. “That’s more like it; our replication strategy now performs very similarly to the average hedge fund.  And when it comes to the pattern of returns, are we replicating the hair-trigger market-timing and monthly swings of the masters of the universe? Yes, we are,” Edwards writes.
“One conclusion to draw is that perhaps there is a market for a product offering a 50/50 split of U.S. bonds and global large-cap equities, at a highly remunerative cost structure.  The other conclusion, perhaps shared by those whose continued flight to low-cost index funds are making the headlines today, is that the average hedge fund looks like a fixed blend of cheap investments, at high cost.”

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