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This episode aired on Bloomberg TV on Jun 28, 2013

Hedge Fund Replicator

Q. So this is one part of the so-called “liquid alternatives” world that aren’t terribly well understood. What are they, exactly?

A. These are exchange traded products that attempt to “replicate” average hedge fund returns. They started coming into prominence a few years ago, around 2007, when some academics started identifying factors — like S&P peformance and yield curves– that correlated strongly to overall hedge fund returns. Once you had a formula, you could create a low fee ETF, and poof, you had hedge fund replicators.

Q. So you made a big point there of saying they try to replicate “average” hedge funds… presumably because they really can’t mimic any given fund.

A. That’s right. But as you know, averages like that tend to mix lots of different strategies, and even more importantly obscures the huge management dispersion that exists in the hedge fund world. Maybe shooting for “average hedge fund” performance was an attractive idea when there were a few hundred of them, now that 10,000 or so exist, it’s a different story.

Q. But assuming you did want to achieve average hedge fund performance, how do these products work, exactly?

A. Well, most have various formulas that rely on different “factors” they think correlate to hedge fund performance. Others actually go into SEC databases and scrape data about hedge fund stockholdings, find trends, and replicate those. But in both cases you are, by definition, looking backwards. To me, the whole point of hedge funds is nimblenssand the ability to adjust to changed conditions quickly, so I’m just not sure about the basic idea here.

Q. But still, I guess the real question is: how different are the reruns on these products from the market over all… What’s the correlation to, say, the S&P?

A. Exactly– there’s the issue. Turns out that the correlation to equities is very high… Overall, investors, so far, are probably not getting what they thought they were buying.