Mixed feelings on hedge fund ETFs

Aug 16th, 2013 | By | Category: Alternatives / Multi-Asset

By David Stevenson –  

The idea of using ETFs to ‘clone’ or ‘replicate’ the trading strategies of hedge funds has always struck me as an idea too far for the passive funds sector.

Mixed feelings on hedge fund ETFs

The Global X Top Guru Holdings Index ETF (GURU), which replicates the holdings of top hedge funds, has been a strong performer.

Let’s be honest, hedge funds tend to typify the polar opposite of what many ETF investors want to buy into. Most ETF investors I know are into low cost investments, passively managed, with low trading turnovers using a strategic approach to asset allocation – hedge funds represent the diametric opposite!

But my objections to hedge fund replication don’t just stop there.

There’s also the ever so small matter of practicalities – or as an old boss once put it, “it’s all down to the execution isn’t it David!” On paper, copying hedge fund strategies sounds a nifty idea but how exactly do you hope to replicate the strategy and thinking of organisations typically built around secretive black boxes and extreme paranoia about any outsider front-running their trading programmes?

In reality you end up with one of two outcomes: best guessing from public disclosures or the development of complex and obtuse screening methodologies that might not actually work.

And if all that wasn’t bad enough, one might also be tempted to question the desirability of tracking the hedge fund community when they’ve been making such a bad job of generating alpha returns over the last year!

So, given all these negatives, why on earth am I thinking about buying a US-listed ETF from Global X Funds that is in fact replicating major hedge funds? The fund in question is the Global X Top Guru Holdings Index ETF (GURU), which is based on the Solactive Top Guru Holdings Index, an index operated by German specialists Solactive (formerly known as Structured Solutions).

According to Global X Funds: “The Top Guru Holdings Index uses a proprietary methodology to compile the highest conviction ideas from a select pool of hedge funds where the 13F information is most valuable. For example, hedge funds with high turnover are eliminated from the pool…Only hedge funds with concentrated top holdings are included in the selection process. Once the hedge fund pool has been determined, the Index Provider utilizes 13F filings to compile the top stock holding from each of these hedge funds. The stocks are screened for liquidity and equal weighted”.

Hedge funds tracked by the index include heavyweights such as Third Point run by Dan Loeb, CQS Cayman, Elliot Management, Fortress Investment Holdings, GLG Partners, Greenlight Capital, Lansdowne Partners, Paulson and Co. Pershing Square Capital, and Tiger Global.

One of the big selling points for this ETF is the cost – the annual management charge is 0.75% compared to the ‘2 and 20’ of hedge fund lore (that’s 2% management fee and 20% performance fee).  And there’s also the positive of decent numbers in terms of returns. Over the month to 12th August the ETF is up 4% (versus the S&P 500 which is up 2.37%), over three months up 7% (vs 4%), six months up 17% (vs 11%), and over one year up 38% (vs 20.5%).

I like the low cost of the fund and those returns numbers are certainly impressive, but my logic for buying into GURU is much simpler – it’s an uncomplicated way of getting beta-plus from developed world, large-cap equities.

If you look at the graphic below, which shows what’s inside the fund, you’ll quickly see that you’re buying a motley collection of stock pickers’ favourites. And that, of course, is the point – these are companies that have been chosen by stock picking hedgies for their potential for capital gain. You still end up with a fairly representative mix of large-cap stocks but with a strong value or opportunistic bias. So whereas the S&P 500 index is very heavily dominated in market cap terms by ‘quality’ stocks, this ETF is a much more focused contrarian and event-driven selection.

My logic is simple. If you think that we are in a cautiously optimistic, risk-on environment, where developed world stocks are likely to outperform, you have a choice which is either straight beta through an S&P 500 tracker or a form of added beta such as the selection of stock pickers’ favourites offered by GURU ETF.

Quite whether the index faithfully replicates every nook and cranny of a hedge fund methodology is sort of beside the point for this fund. This index and the accompanying ETF will give you juiced up exposure to stocks attracting opportunistic interest in major world markets.

In this sense I’m less worried about this fund than I am about other hedge fund replication strategies where you’re trying to figure out how a CTA, for instance, uses advanced algorithms to look at futures markets. Frankly, if a passive quant-driven replication strategy does actually successfully mimic these hedge funds, I very much doubt it’d be sold to retail investors via an ETF. Surely, it would be offered as a conventional hedge fund?

This index and accompanying ETF by contrast is simple stock picking without all the question marks about whether you need to go long/short…or introduce gearing! It picks stocks by focused stock pickers and then gives you the beta of the market. Simple. It will, of course, probably be an absolute stinker if we suddenly enter a risk-off environment where stock pickers are punished……but my suspicion is that we’re still quite some way from this market environment.

Global X Top Guru Holdings Index ETF (GURU)

Fund profile: Global X Top Guru Holdings Index ETF (GURU).

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