Hedge Fund Replication Strategies and Examples
For the vast majority of investors, hedge fund investing could be out of reach. Funds can have very high minimum investment requirements and net worth restrictions, or be closed to new investment entirely. However, in October, 2020, academics from the National University of Singapore found that market risk factors explain up to 81% of hedge fund portfolios’ variance. Based on this information, the team created hedge fund “clones” composed of public market instruments that it claims were able to outperform hedge fund indices.
Certain ETF and mutual fund providers believe that their products have the potential to replicate hedge fund strategies. – giving access to investors who might otherwise be locked out of investing directly into a hedge fund. Below, we provide a summary of some of these replication strategies and look at an example of each.
Factor replication strategies are based on the idea of “hedge fund beta” – identifying the market risk exposures that comprise hedge fund returns. Funds would then aim to monitor monthly hedge fund returns and use weighted baskets of public market instruments to replicate them. Funds that utilize factor replication strategies could have much lower minimums than traditional hedge funds.
This ETF seeks to track the performance of the Merrill Lynch Factor Model – Exchange Series, a replication model which is designed to provide “the risk and return characteristics of the hedge fund asset class.” It targets a high correlation with an index that tracks hedge fund industry performance. This index, the HFRI Fund Weighted Composite Index, is made up of 2000 equally weighted constituent funds. The replication model uses the following factors: S&P500, Russell 2000, MSCI EAFE, MSCI Emerging Markets, ProShares UltraShort Euro ETF, and 3-month Treasury Bills. According to fund documents, total return based on market price from the fund’s inception on July 12, 2011 to the quarter ended December 31, 2021 is 2.6% on an annualized basis. The expense ratio according to the fund is .95%.
Fund of Funds
A fund of funds is an investment vehicle where investors’ capital is pooled together and invested into other funds. Fund of funds could be used by individual investors to access funds that they might be restricted from investing in directly. For example, a mutual fund with a relatively low minimum could have underlying exposure to hedge funds.
Structured as a daily liquid mutual fund, FSMMX aims to “generate positive, low-correlated returns over a complete market cycle” through a combination of alternative beta strategies and investments in active hedge fund managers. The composition of the fund as of 1/31/2022 was 61.2% alternative beta and 38.8% active hedge fund managers. Since inception the fund has had positions in the following hedge funds: MidOcean, Basso, Chilton, and Crabel. According to fund documents, total return of the fund’s Class A shares from inception on May 16, 2017 to the quarter ended December 31, 2021 is 3% on an annualized basis, gross of sales load. According to the fund, the maximum sales charge for Class A shares is 5.75% and the total annual fund operating expenses is 3.42%.
Copycat funds aim to mimic the actual holdings of hedge funds. While hedge funds can have relatively low disclosure requirements, they do typically disclose their holdings on a lagged quarterly basis. Copycats will seek to take this publicly available information from select hedge funds, screen it for certain criteria, and build portfolios from the identified securities.
This fund seeks to track the performance of the Solactive Guru Index, “comprised of the top U.S. listed equity positions reported on Form 13F by a select group of entities that Solactive AG characterizes as hedge funds.” The hedge funds themselves are filtered by size of reported equity holdings and efficacy of replicating their positions, eliminating funds that have high turnover of holdings. The index provider will then compile the top stock holdings listed, screening for liquidity and equally weighting them. According to fund documents, total return based on market price from the fund’s inception on June 4, 2012 to the quarter ended December 31, 2021 is 14.2% on an annualized basis. The expense ratio according to the fund is .75%.
This content is for informational purposes only and not intended to be investing advice. Masterworks does not recommend, promote or have an existing relationship with any of the institutions mentioned.