Chapter Eleven

One-Fund Solutions

Destroy All Replicants—or Not?

Unless you have vast personal resources and skill in selecting fund managers, real hedge funds are not going to serve as good diversifiers for your portfolio. A friend has a stockbroker who recently recommended a hedge fund to him with an unbelievably great track record. This is exactly the wrong way to proceed. The rule of thumb is that you start with a survey of the field in relation to your needs and then do 75 to 100 hours of research on any hedge fund manager you select.

If you check your piggy bank, you probably don’t have enough money to buy all the conventional asset classes plus an extra million dollars apiece to get into a sampling of the 10 different hedge fund strategies. If you have a half-million dollars to throw at this you might invest in a hedge fund fund-of-funds, but you still have to pick the right manager, which means you are back to the 75 to 100 hours of research.

No need to despair if this is not your situation. These new hedge-funds-in-mutual-fund-wrappers are going to provide an alternative.

There are two different methods used by these hedge fund mutual funds. Both try to deliver hedge fund performance, but they arrive at this place following completely different routes.

1. Hedge Fund Replicants: A top-down approach to mathematically replicate the returns of hedge fund indexes. We’ll call these “hedge fund replicants,” which has a nice sci-fi ring to it. They recreate hedge fund returns either using other mutual funds, or by using various combinations of stocks, bonds, commodities, currencies, and so on to get exposure to the set of risk factors they need.

2. Hedge Fund Strategies: A bottom-up approach, pursuing the actual hedge fund methodology itself zipped up inside a mutual fund.

We are ready to start naming names.

In this chapter, we call out some funds, first those that are replicants and then those that follow hedge fund strategies. We close by talking about our pitiful efforts to create our own long-only hedge fund.

Hedge Fund Replicants

By analyzing databases of hedge fund performance, math wizards (primarily William Fung and David Hsieh, Harry Kat and Helder Paloaro, Andrew Lo and Jasmina Hasanhodzic) discovered how to clone hedge funds by using ordinary ingredients like those you already have lying around the kitchen. In effect, the quants quantified the quants. Sometimes these replicated funds were used by institutions to give their clients a place to stash their alternative dollars during any interregnum between hedge fund investments.

How did they do it?

In effect, the quants quantified the quants.

It’s a little bit technical, but basically the replicants take the data series of hedge fund returns and do a regression analysis to reproduce it using a set of conventional risk factors: so much stocks, so much bonds, so much currencies, so much commodities, so much credit, so much volatility, and Shazam!—they have it. The replicant funds triangulate the hedge fund returns the same way Frankenstein was reverse-engineered from graveyard body parts. They end up with a synthetic hedge fund that mimics the behavior of the real thing—not precisely, but in a way that’s good enough for home use.

The formula can be applied to all hedge funds taken as a group, or it can be applied to each hedge fund strategy taken individually. This approach washes out all the idiosyncratic fund manager contributions to the total returns and extracts just that portion attributable to their exposure to common underlying risk factors.

This all sounds sexy until you look under the hood. For example, a hedge fund replicant might contain 40 percent corporate bonds, 20 percent emerging market stocks, 11 percent small cap stocks, and so on—a lot of the same stuff we already own. Of course, it shouldn’t matter if it contained two bus tokens, some pocket lint, and a stick of chewing gum, so long as it delivers the goods. As we have seen, most investors are overexposed to one specific risk factor (equity risk) and underexposed to the others.

With that in mind, we begin with some hedge fund index funds that have been spawned by replication. Normally we would like to lead off by showing you a comparison of their performance over the past three years, but these funds are all comparatively new.

ING Alternative Beta

This fund (ticker: IABAX) is a straightforward attempt to capture the beta of the Hedge Fund Research Index (HFRI), an equally weighted composite of more than 2,000 hedge funds. It uses derivatives in various liquid financial market indexes such as equities, fixed income, currencies, and commodities to track the index.

Natixis ASG Global Alternatives

This fund (ticker: GAFAX) is the brainchild of Professor Andrew Lo, head of financial engineering at MIT and pioneering researcher in hedge fund beta replication. What AlphaSimplex Group (the fund managers, the “ASG” in the fund name) brings to the clambake is active risk management. Lo takes the view that investors do not like to lose a lot of money. The fund manages its volatility (i.e., standard deviation) to an 8 percent target, adding either leverage or cash to keep it at this level. Since volatility is generally the enemy of returns, the fund automatically becomes more defensive when the going gets tough, but then adds leverage to increase returns when seas are calm. The fund makes direct long and short investments in about 26 futures and forward positions to capture the hedge fund betas from the Lipper TASS database of 3,000 hedge funds.

Fun, Fun, Funds ’til Her Daddy Takes the T-Bill Away

We interrupt this chapter to bring you the following public service bulletin.

Since we have just started name-dropping some particular alternative mutual funds, we need to pause here and issue a bunch of disclaimers. As we survey the specific mutual funds here and in the chapters ahead, please keep several things in mind.

The funds we suggest tend to be new and have short track records. We don’t have a 75-year data series to analyze that would speak for itself. We can only go by what we see: the bland strategy description from the prospectus (probably written by the fund’s legal department), the expense ratio, and whatever short-run correlations and returns we can uncover. Even something as straightforward as a fund’s expense ratio can be tricky to pin down, since the sponsoring company will often underwrite a large part of a fund’s start-up costs in the hope of attracting a self-sustaining pool of money. We wish we had more to go on, but we don’t, so we will try to make the best of what we have.

If there is some fund that you love that is not mentioned here, it could be for several reasons. One is that it didn’t turn us on. Another is that we overlooked it. Don’t ask which. There are many funds out there in fundlandia. We have tried to characterize the ones here accurately and apologize in advance if we have failed in this mission.

Most funds have different share classes available. There are funds with front-end, level, and back-end loads (commissions) as well as funds with no loads. There are investor and institutional classes of shares. We have not listed all the share classes of every fund, but we will typically list one or two. You can look them up if the fund interests you. We will include a little information about each one in the Appendix, and you can dial your web browser to Morningstar.com to learn more.

Which share class you are eligible to buy depends on whether you are investing on your own, through a broker, or through an investment advisor, as well as which custodian holds your account and how much money you have to invest. If you have an investment advisor, sometimes he can get you into institutional class fund shares that have a high stated minimum dollar investment for less than that amount. Sometimes he can’t. This isn’t a democracy. Not everyone will be able to get into all share classes of all funds.

Many of these funds have short-term redemption fees. Some will even have the dreaded mutual fund marketing fees (known as 12b-1 fees) attached, if they aren’t banned by the time you read this. You know how they always say to read the prospectus? This isn’t an S&P 500 index fund. Get out a magnifying glass and read the prospectus. It won’t be very enlightening, but at least you will be better off than the guy who hasn’t read the prospectus.

The conventional wisdom on mutual funds is that the best single screen to use is a fund’s expense ratio. Since most mutual funds are delivering a market return net of their expenses, the lower the expenses, the better their return. That is not true here. These funds can have high management fees because these managers are competing with well-paid hedge fund talent (in some cases, the same managers are running both hedge fund and mutual fund versions of the same strategy). The research they use doesn’t come cheap. The internal expense ratios for these funds will flip your wig. When funds are operating high turnover strategies and using leverage and passing through dividends on stocks they are shorting, the annual expenses can run to 15 percent or even higher. Most don’t have operating expenses this high, but some do. It doesn’t mean the managers are taking their Netjets to the Seychelles. This is the price of running the strategy, the cost of doing business in this space. We wish it were cheaper, but it’s not.

In the final chapter we will talk about how an investor might integrate all of these alternative investments with the rest of his or her portfolio. For now, consider all these funds we are listing as a starting lineup of American Hedge Fund Idol contestants. If your eyes start to glaze over while reading about specific funds, just skip this part and return to it later as your interest sharpens.

We now return you to your regularly scheduled programming.

Multi-Strategy

For readers who can remember as far back as the last chapter, another approach we mentioned for the investor who wants to pick just one hedge fund type is to use a multi-strategy fund. These funds do not try to replicate the entire hedge fund universe, but they pick from several strategies within it.

The first two funds that we recommend rely on the replication approach.

IQ Alpha Hedge Strategy

The Index IQ (ticker: IQHIX) uses a regression analysis to replicate the performance of each of six of the basic hedge fund strategies mentioned previously—long/short, macro, market neutral, event-driven, emerging market, and fixed-income arbitrage—and reconstitutes their performance using off-the-shelf, plain vanilla exchange-traded funds. They then combine the six factors according to their own formula, and apply up to 25 percent leverage to the results. The idea is to be in market directional strategies during periods of low market volatility and then rotate into market neutral strategies during periods of high market volatility. The correlation of this fund to the S&P 500 has been about 0.76 since late 2007.

IQ Hedge Multi-Strategy Tracker

This fund (ticker: QAI) employs the same strategy as IQ’s “Alpha” fund above, but without using leverage. This is an exchange-traded fund that anyone can buy or sell without paying a sales load, and it operates with low expenses.

The next group of multi-strategy funds is not trying to track an index or replicate a benchmark. They pursue multiple hedge fund strategies in their own right, working them inside the mutual fund format. As such, their returns can be expected to vary from those of hedge fund indexes in aggregate. We are getting fund-specific returns, not those of a broad index.

iShares Diversified Alternatives Trust

This exchange-traded fund (ticker: ALT) tries to capture fixed income arbitrage, managed futures, and global macro hedge fund strategies. It makes direct investments in futures contracts to achieve its goals, without the further intermediation and expense of using exchange-traded funds.

Natixis ASG Diversifying Strategies

This fund (ticker: DSFAX) uses a half-dozen hedge fund strategies, including macroeconomic, fixed income, and trend following models, and as far as we can tell, it tries to overweight whatever is working best right now. Here the special sauce is correlation management: When the fund’s correlation to the stock market rises above 0.25, they short the stock market component until the correlation falls back to 0.25 or below. This is a significantly lower correlation to the market than that embedded in the hedge fund replicants above, and that makes this fund more hedgy. It also manages volatility to a standard deviation of about 12 percent.

Let us pause here and take this in. This fund actively manages two characteristics that are very important to investors whether they know it or not: correlation to the market, and volatility. This means that the fund will (a) not be just another closet stock market index fund, and (b) that it has a pressure valve on top to let off steam when things get too hot. These are exactly the kinds of bells and whistles that ought to make retail investors take notice. This isn’t your grandmother’s mutual fund. We’re starting to use space age materials. If the execution on the strategy side proves to be good as it is on the risk management side, we will be onto something.

All the above are possible one-fund solutions that let you easily add the hedge fund universe to your portfolio. There is one other avenue to consider before we jump into the strategy-specific funds.

Alternative: Roll Your Own Hedge Fund

At the end of 2007, your authors published their classic tome, Yes, You Can Supercharge Your Portfolio. Beneath the breathless title was an attempt to introduce Monte Carlo simulation to retail investors, an introduction we believed was overdue.

Almost as an afterthought, we suggested that an investor could create his own long-only, mini-hedge fund just by selecting stocks with a low correlation to the rest of the market. We were even foolish enough to create a shovel-ready 10-stock portfolio to accomplish this. The companies we picked at the time were:

Little did we know at the time that this casual theorizing would instantly be subjected to the slaughter of 2008. With fear and trembling, we peeked back at how this make-believe 10-stock hedge-fund-lite portfolio performed in 2008, and we were crushed to see that it was down fully 14.6 percent. Some hedge, we thought. We were thankful that we at least had the foresight to write that these companies would regress to the mean going forward, but even so they might present something of a hedge.

Upon further reflection, however, we realized that an S&P 500 index fund was down 37 percent for the year, so our little long-only 10-stock portfolio was still about 22 percentage points to the good.

Then we noticed that the Dow Jones Credit Suisse Hedge Fund index was down 18.7 percent that year. We had even managed to beat that—and without being smart, sophisticated, and above all, well-paid hedge fund managers. In fact, for 2008, this portfolio outperformed the Dow Jones Credit Suisse Convertible Arbitrage Index (down 30.6 percent), the Emerging Markets Index (down 29.5 percent), the Market Neutral Index (down 33.6 percent), the Event Driven Index (down 17.5 percent), the Fixed Income Arbitrage Index (down 27.9 percent), the Long/Short Equity Index (down 19.2 percent), and the Multi-Strategy Index (down 23.3 percent). It was trounced by the Global Macro Index (down 4 percent), the Managed Futures Index (up 19.1 percent), and (naturally) by the Dedicated Short Bias Index (up 16.8 percent). Of course, in 2009 it sat there like a log, but it did hedge a bit when it counted.

The fact that our performance was competitive raises an interesting question: does the emperor have no clothes? Can anyone create a long-only stock portfolio that is relatively disconnected from the fate of the larger stock market of which it is a part? Is there another road that gets us to the same place, bypassing the high-priced talent?

Let’s revisit how we came up with our 2007 long-only, unlevered mini-hedge fund.

First, we looked for stocks whose price swings were uncoupled from those of the larger stock market.

Then, we eliminated stocks whose price swings were too volatile, whether or not they were correlated with the S&P 500.

Next, we screened for fundamentals: We eliminated companies who didn’t have enough daily trading volume to make them readily liquid. We cut those who had recently trimmed their dividends for any reason, as well as those whose payout appeared suspiciously high. We gave the ax to corporations with no earnings. Finally, we struck from the list any whose price/earnings ratio was more than 25, which meant that they were just too expensive for us poor country boys. We made some effort to select from different industries, including food, banking, insurance, tobacco, utilities, medical equipment, packaging, beverages, drugs, and energy. Note that the list is all stocks—no bonds, no commodities, no REITs.

Our final step was to assemble them into an equally weighted, 10-stock portfolio, using the QPP Monte Carlo simulator. Not only did we want the stocks to have a low correlation to the stock market, we also wanted them to have a low correlation to each other, to maximize diversification.

Would we buy this portfolio today? Not a chance. The list needs updating, since the dynamics of the stocks change relative to the market. For example, we would certainly have jettisoned a financial like Pacific Bancorp early on and replaced it with something better.

Here’s another change we would make: We would take a tip from Quantext wizard Geoff Considine and add a screen for stocks that do badly under conditions of high market volatility. Volatility rises sharply in times of panic, so stocks tank as volatility spikes. We wanted off that ride.

The same companies tend to come up again and again when we use these screens. Our new portfolio consists of the following. Note, we’re still equal-weighting them.

This portfolio reads well on paper. It has a low beta, a low volatility, and a low correlation to the market’s volatility. It could provide a useful hedge to a conventional stock-and-bond portfolio.

With our luck, these companies will have gone out of business by the time you read this, but here they are anyway. But, in case this doesn’t happen, should you buy this portfolio yourself? Only if you understand what you are doing and are willing to monitor all these factors going forward.

Bottom Line: This portfolio would be a satellite to the rest of your holdings. You could use this in conjunction with the other hedge fund strategies, or you could skip this step altogether. We just wanted to show you that lurking within the forest of the stock market were trees that could build a hedge all by themselves.

The Alternative Reality

There are workable one-fund offerings that offer an alternative not only to stocks and bonds, but also to buying a whole slate of individual hedge fund mutual funds. Some of these—replicants—use mathematics to reformulate the performance of hedge fund indexes using other means. Others run a mixture of different strategies inside a mutual fund wrapper. We have seen that it is even possible to create a hedge fund by choosing stocks that behave differently from the rest of the stock market.

However, before we commit ourselves to a particular course of action, we need to survey what else is out there. These would be the mutual funds dedicated to running a single hedge fund strategy.