So, What About Hedge Fund Replication ETFs?

The latest ETF Report asks Can An ETF Replicate A Hedge Fund? It's a quick article that talks about the way that hedge fund replication funds can try to mimic hedge funds. I think this is the wrong question. I am of course a huge believer in small allocations to funds that help reduce correlation to the broad market and help to reduce volatility compared to the broad market but I believe this needs to be an active process, not active as in heavy trading but the realization that holding a 3% weighting in some sort of alternative or hedge fund replicator may not be a great idea for the entire duration of the stock market cycle.

As someone who uses alternatives including hedge fund replication, as opposed to trying to mimic hedge funds (whatever that really means), it makes more sense to figure out what attributes you're trying to add to your portfolio and then search for what you think is the best way to add those attributes.

Consider the Alpha Clone Alternative Alpha ETF (ALFA) and the Global X Guru Index ETF (GURU). Both populate their portfolios with reported holdings of hedge funds through 13-f filings. These funds attempt to outperform the broad market. Looking at the last three years GURU is far ahead of the S&P 500 (per ETF.com) while ALFA is noticeably lagged behind. For five years both funds lag by a lot. You can draw your own conclusion as to whether either fund does anything to set expectations for long term outperformance but that is the question with these two funds.

Another type of popular hedge fund strategy is long/short. This chart shows the S&P 500 versus the WisdomTree Dynamic Long/Short U.S. Equity Fund (DYLS) and the AGFiQ U.S. Market Neutral Anti-Beta Fund (BTAL) which is a client holding.

The word dynamic in DYLS' name means it can change the long/short mix. It appears to have changed it's mix close to the low in December and has mostly missed the rally to start 2019. For most of its existence, DYLS has looked like the broad market, albeit with a slight lag and deviated late in 2018 which I take to mean it intends to have a high-ish correlation to the broad market making it more of a market proxy (my conclusion based on its performance). For most of its existence, BTAL has looked nothing like the broad market making it less of a market proxy (my conclusion based on its performance).

I would not view DYLS as a hedge fund replicator that will necessarily reduce correlation and volatility but I believe BTAL does reduce correlation and volatility, this has been my experience with it. Anyone believing in any of this, and anyone thinking DYLS sets the expectation of managing volatility then they might consider using that fund but that is the question which is less important than whether the term hedge fund has any relevance.

There is nothing wrong with feeling all of this is unnecessary. I believe in it, maybe I have been lucky with it but the key to understanding these things is having the proper expectation of the actual strategy of the fund and then being satisfied that the fund can meet the expectation it is trying to set.