“Homemade Hedge Funds”: Delicious but deadly?

As investors attempt to look behind the hedge fund wizards’ curtains to see how they perform their tricks, there is a significant amount of interest in “do it yourself” or “homemade” hedge funds.  This Business Week cover story from late 2005 is a great example (check out the rather heated comments too).  During the ensuing 2 years, “homemade hedge funds” came to be known as “hedge fund replication”.

But most of the debate surrounding “hedge fund replication” has involved the use of futures, swaps, mechanical trading strategies, derivatives.  But most investors simply don’t have these tools lying around at home.  So an asset manager and an academic from Howard University recently teamed up to see if you could actually replicate hedge fund returns using the most common of household appliances – the sector ETF.

In “Homemade Sector Hedge Funds: Can Investors Replicate the Returns Without Paying the Fees?” Lorenzo Newsome of Xavier Capital Management and Pamela Turner of Brown University say this has never actually been tried before.  (Their paper appears in this quarter’s Journal of Investing and can also be downloaded here.)  Say the duo:

“The research question we address in this paper is whether investors, by following a trading strategy, can replicate the returns (absolute and risk-adjusted) of single sector hedge funds (SSHFs) by investing in ETFs… To our knowledge, no other researchers have attempted to compare returns of ETFs to SSHFs based on a predetermined trading strategy. Kat and Palaro [2005] present a case study of replicating hedge fund returns. They provide examples and show what if results.”

They compared the 6 sector-specific sub-indices of the HFRI with the corresponding sector Spiders.  They couldn’t pair up two of them and were left with four: Financials, Energy, Tech and Healthcare.

They proceeded to compare the reurns of the HFRI sector indices with the returns of a long Spider position, with those produced by two mechanical variants on the Relative Strength Index (RSI) (a long-only variant and a long/short with leverage variant).

The news is good for those who warn investors not to “try this at home”:

“…the hedge fund dollar returns are significantly higher than any of the RSI strategies. This evidence suggests that on an absolute basis, hedge funds are viable investment options and their returns cannot be mimicked with trading strategies (at least not the ones used here).”

The long/short RSI strategies generally, but not always, beat the long-only strategies.  Energy hedge funds blew away the energy ETF and its corresponding RSI strategies.  Hedge funds specializing in the financial services sector edged out financial ETF RSI strategies, but handily beat a financial ETF buy-and-hold strategy.  In the healthcare sector (chart below), the hedge funds beat the RSI strategies, which in turn, beat the ETFs themselves.  And in the tech sector, hedge funds produced a modest return vs. a flat return for an RSI strategy using shorts and leverage and a negative return for a long-only RSI strategy and the tech ETFs themselves.

Of course, the notion of designing your own hedge fund at home using mutual funds (as Business Week first proposed) or using ETFs (as Newsome and Turner suggest) is alive and well.  It’s just that you better have some special talent for make-at-home projects since a passive approach may come up short.

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