As we reported in our weekly newsreel on Monday, Goldman Sachs just launched a mutual fund based on its recently-launched hedge fund replication index called the “Absolute Return Tracker” (ART). As the FT reports, the fund aims to highlight how a large proportion of hedge fund returns are just “exotic beta” not true alpha.
“The underlying theory makes sense. Some of hedge funds’ performance is down to alpha, or fund managers’ skill. For that, for now, you will continue to have to pay fees.
But a large amount of it is beta. In other words, it is predictably correlated with various markets. Absolute return managers will tend to cluster around similar asset allocations; it is possible to model this behaviour; and hence it is possible passively to capture a large chunk of the value that absolute return managers deliver, and pay much less for it.”
The nuts and bolts behind “ART” are a state secret, but the fund’s prospectus describes it this way:
“…the Fund seeks to achieve investment results that approximate the performance of the Goldman Sachs Absolute Return Tracker Index (the GS-ART Index), a proprietary Goldman Sachs International (GSI) index that seeks to replicate the investment returns of hedge fund betas (i.e., that portion of the returns of hedge funds, as a broad asset class, that results from market exposure rather than manager skill). GSI maintains the GS-ART Index to reflect the returns of a basket of market indexes (the Component Market Factors). The Component Market Factors are determined by an algorithm that seeks to approximate patterns of returns of hedge funds as a broad asset class. On an annual basis, GSI identifies the Component Market Factors that will be included in the GS-ART Index for the coming year. On a monthly basis, GSI applies the algorithm to objectively re-weight each of the Component Market Factors within the GS-ART Index. The weight of each Component Market Factor may be positive or negative and is subject to certain maximum absolute values.”
Got that? If not, you may not be alone. As the FT observes:
“A key issue here could be simplicity. The ever-expanding panoply of passive exchange traded funds is based on some impressive financial engineering, and some cutting-edge academic research. But there is still something fairly straightforward about them. An investor in an oil ETF can say “my investment will go up if the oil price goes up”, and so on.
It is hard to reduce the new Goldman Sachs offering to anything so simple.”
In any case, we think this is a worthy pursuit. But it’s always been curious how long-only funds rarely undergo the same kind of scrutiny. Obviously, ETF providers have long argued that mutual funds can essentially be “replicated” by using index ETFs. But if any asset class “tends to cluster”, its long-only funds.
For example (not to pick on GS), Goldman’s Large Cap Value Fund (GSLAX) charges 1.2% and has a 3-year beta of 0.97 (with a market correlation of 0.96). Just check out the 5 year return vs. the Spider(from Yahoo! Finance, Blue-GSLAX, Red-SPY)
Assuming you could buy the market for, say, 30 bps annual management fee), you’d be paying almost 4.5% for the active management component of this fund (see page 9 of this excellent paper on the “true costs of active management” for the calculation methodology used).
This assumes that once the market return is removed from the equation, all that remains is pure alpha (manager skill). However, there are likely exotic betas embedded within this alpha – just as there are within hedge funds’ “alpha”.
Let’s assume GARTX shows the same market correlation as a broad hedge fund index such as the HFRI Fund of Funds Index (0.45). Using the same formula as above would show that the active component of GARTX would cost only about 2.25%. So if any active strategy should be replicated, perhaps it ought to be long-only value, not hedge.