Pendulum swinging back to investable hedge fund indices for passive HF exposure

Passive investment in hedge funds has always been somewhat of an oxymoron.  Hedge funds, after all, aim to deliver active management (alpha).  And since alpha is a zero sum game, a passive investment in hedge funds should deliver a zero return.  Nonetheless, this axiom has always been challenged by proponents of various products designed to deliver aggregate “hedge fund returns”.

First there was the passive fund of funds; then came the investable hedge fund index; and finally there was hedge fund replication.  In essence, all of these products delivered similar value propositions: diversification, transparency, and liquidity.  (Despite the tendency for these providers to compete on returns, out-performance was never officially the goal of these “passive” products).

Hedge fund replication seemed to be the story of the year in 2008.  But in the post-Madoff environment, the pendulum may be swinging back in the other direction.  The investable hedge fund index – derided by proponents of hedge fund replication as being expensive and opaque since it invests in hedge funds themselves – is making a comeback.

The irony with many hedge fund replication products is that their hedge fund return-replicating algorithms are often so complex that they begin to look more like the quant hedge funds they aim to supplant.  This is a weakness exploited recently by Deutsche Bank, for example.  The firm announced the launch of its new ETF of hedge funds this week (The DB x-trackers Hedge Fund ETF). has a good write-up about the product here.

Clearly aiming to cash in on the ETF craze,  Deutsche Bank bills the ETF as “the world’s first ETF on hedge funds.” To the layman (i.e., us), the product sounds a lot like the MSCI Hedge Invest index, one of several investable hedge fund indices that has been around for some time (factsheet).  But the difference, of course, is that DB’s offering is exchange-traded (in Frankfurt).

Both the new DB fund and the MSCI offering (which is actually just an index to be “licensed for use as the basis for tradable investment products” according to the firm) are based on a set of managed accounts, special accounts owned by DB, but managed by the hedge fund manager.  Unlike DB, though, MSCI chose to outsource the management of these accounts to a third party (Lyxor, the SocGen subsidiary).


Not content to watch Deutsche Bank get all the investable index limelight this week, Hedge Fund Research (HFR) just announced that it was rolling out 38 (yes, 38) new HFRX indices.  Regular readers will remember the HFRX as the lower-performing, but investable cousin of the venerable HFRI Index.  Unlike both MSCI and Deutsche Bank, the HFRX is based on the return of funds that hold the eventual allocations directly, not via managed accounts.  And unlike DB’s new ETF, it’s not exchange traded.

Hedge fund replica vs. hedge fund ETF

If you’re really into this kind of thing, you might now be wondering how DB x-tracker ETF ranks vs. the much heralded DB Absolute Return Beta (“DB ARB“) hedge fund replicator launched about 18 months ago (see related post).  We certainly were.

Both are designed to provide passive access to hedge funds in a liquid and transparent manner.  However their performance is quite a bit different as you can see from the charts below (from DB’s index website – click charts to view original pages).

DB Absolute Return Beta (“DB-ARB”)

DB x-tracker hedge fund ETF (back-tested)

As you can see, the DB ARB fund fell around 30% from mid-2008 to early 2009 while the back-tested ETF fell by only 15% (closer to the return of the hedge fund industry in general).

So does this mean that hedge fund replication failed in its promise to replicate industry returns?  Not quite.  Other replication products fared better last fall – more closely matching the returns of hedge fund industry.  Goldman’s Absolute Return Tracker (ART), for example, was only off about 20% during the same period, Merrill Lynch’s Factor Model was off around 15%, and SocGen’s T-Rex product was also off by around 15%.

But still, results like these seem to suggest that some complex hedge fund replication algorithms still could use a little refining.  This complexity is what is making some investors nervous about hedge fund replication and drawing them to the managed accounts that make up the DB and MSCI investable indices.  So despite their distaste for paying high fees to underlying hedge funds (plus a 90 bp ETF fee), these investors may end up holding their noses and investing in them.

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  1. Harry M. Kat
    March 19, 2009 at 2:42 pm

    The two graphs also show that DB ARB is more volatile than the ETF, which explains why it lost more. In fact, wasn’t that higher volatility the big con behind DB ARB? Remember their marketing slogan: “We replicate gross returns”. As if you can do that without taking more risk. After 14 months of crisis (great job Mr. Paulson!) it is quite amazing to find investors still interested in traditional hedge fund replication. Haven’t they figured out by now that hedge fund indices just aren’t worth replicating? And even if, you don’t need a complex algorithm for that. Put the bulk of your money in T-bills, aind invest the rest in the S&P and a little CDS and hoopla. Replicated. Complex? Not at all. Try building a space shuttle. Now that is complicated.

  2. bill
    March 19, 2009 at 4:29 pm

    strictly speaking, a passive investment in hedge funds can deliver positive alpha. this just means that hedge funds as an asset class are delivering average positive alpha, and other active investors are delivering average negative alpha. alpha still sums to zero.

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