A Hedge Fund Manager’s View on why they have struggled and why the future finally looks bright.
A dozen years after the launch of the first alternative ETFs, not a single one has more than $1 billion in assets and only five have more than $100 million. While there are hundreds of alternative mutual funds, there are, at best, a few dozen alternative ETFs – a figure that is dropping with the announced closure of several products over the coming weeks. The inescapable conclusion is that the alternative ETF space, to date, has been a dismal failure.
The existential question today is: Do alternative ETFs have a future?
In this article, I make the argument that the answer is yes: in fact, alternative ETFs have a surprisingly bright future. That said, I also argue that responsibility for the lack of traction lies at the feet of product developers: the current universe of ETFs, by and large, is ill-suited to the needs of the most important investors. I will then pivot to how we believe the space should evolve and what is likely to drive widespread adoption.
For purposes of this article, “alternative ETF” is defined as long/short hedge fund strategies like managed futures and equity long/short, not long- or short-only products in commodities or other areas.
Structural Problems with most Alternative ETFs
Simplistically, we break down the ETF investor base into two camps: model portfolio allocators and active traders. The former tend to think in terms of diversification among asset classes, long term capital markets assumptions, glide paths, and fee efficiency. The latter tend to want high volatility products to make aggressive tactical bets on rising or falling prices – e.g. 2x oil ETFs. The problem we identified several years ago is that most alternative ETFs were built for neither camp: too complicated and unpredictable for model allocators, and not volatile enough for active traders. Consequently, they ended up in the marketing equivalent of no man’s land.
In theory, hedge fund-like ETFs should be highly valuable diversifiers in model portfolios. (We see no relevance to active traders and hence will focus solely on the model space.) The threshold question is, why (and how) model portfolio allocators would decide to include hedge fund-like strategies? All models are built using “capital markets assumptions” – expectations of how dozens of asset classes will perform and interact over the next decade or longer. Those assumptions are fed into a quantitative model that generates optimal weights given a specified level of risk. The inclusion of hedge fund strategies as a complement to traditional assets tends to dampen volatility and improve overall risk-adjusted returns; hence, virtually every institutional investor has a hedge fund bucket today.
Yet few ETF-based model portfolios do. To answer why, we need to first delve into what we mean by an “allocation.” Importantly, capital market assumptions are built using data from a hedge fund index – itself a collection of returns of dozens or hundreds of actual hedge fund managers. Therefore, if the model sets a 5% “allocation,” it seeks exposure to a very diversified pool of hedge funds that pursue a similar strategy. In the same way, the model might set exposure to “US large cap equities” based on the S&P 500 index, not Apple. What is clear is that the model is not saying that it wants exposure to a single hedge fund.
And this is precisely where alternative ETF product design fell short. To be more specific:
- Single manager ETFs are too risky for model portfolios. Within a given hedge fund category, top and bottom performers will be 30-40% apart each year. A single manager, then, is statistically likely to underperform the benchmark by 20% or more at some point over the coming few years – a divergence that is incompatible with the ethos of predictability in ETF model portfolios. Consequently, single manager products, in our view, will never gain significant traction in the model space.
- Passive strategies that track irrelevant indices are just as risky. “Passive” evokes “low risk” and “predictable.” This is a landmine. There is no purely passive way to get exposure to hedge fund-like strategies. One type of alternative ETFs tracks indices that have little relationship to the hedge fund strategies; others use self-manufactured indices which are simply single manager strategies that have been systematized – essentially, both carry the same risks as above. Neither is appropriate for model portfolios.
Taken together, the lack of traction of 90% or more of products in the space is not only understandable, but predictable.
How Alternative ETFs Need to Change
It follows, then, that alternative ETFs need to be reconfigured for the logical audience: model portfolio allocators. Based the objectives and construction methodology of model portfolios, those ETFs should meet one simple criterion: Consistently match or outperform actual, strategy-specific hedge fund indices.
These ETFs complete the loop: model allocators build capital markets assumptions using hedge fund indices, then invest in ETFs that in turn track those indices over time. Note two things. First, we also say “strategy-specific”: thirteen years ago, “hedge funds” was a single strategy but today most view it as a collection of individual strategies, like managed futures and equity long/short; we believe allocators want the flexibility of strategy-level building blocks. Second, we believe that, to the extent possible, complexity and extraneous bells and whistles should be scrapped for “simple and efficient” to better align with the ethos of the ETF world.
The question is what strategies can plausibly deliver on this promise. Having studied the space for over a decade, our conclusion is that the only viable solution is top down, factor-based hedge fund replication. Those strategies start with a very diversified pool of “target” hedge funds, use quantitative models to determine their core positions, and invest in instruments like futures and ETFs to mimic the same exposures. The strategies, then, are something of a hybrid: technically “active,” but with index/passive diversification. Carefully-designed products with live track records back to 2007 have consistently matched the performance of hedge funds with high correlations – hence, they have not only stood the test of time through various market cycles, but a model allocator could be confident that they might do the same over the coming ten to twenty years.
Our view is that demand for alternative ETFs will be driven by more innovative model allocators who start with a better understanding of hedge fund-like strategies. Marketing to them may focus primarily on education – what lessons can be applied from both hedge funds and the broader liquid alts space – and consultation on the realistic benefits of hedge fund strategies in a broader portfolio. In addition, marketing should address how these benefits can be incorporated into the model’s value proposition and articulated to end clients. The proverbial army of boots on the ground will add less value since, like institutional consultants, model allocators serve as gatekeepers to large pools of investors. In short, alternative ETFs will be bought, not sold.
The demonstration of value added could drive further growth. Early adopters will differentiate themselves from competitors on the basis of sophistication, risk mitigation and smoother glide paths. Ultimately, success of a few products will bring more asset managers into the space, and those product providers will join in the education process and expand the investor base. As understanding grows and the cost of managing ETFs continues to decline, some larger, follow-on entrants may even build bespoke ETFs capitalized by their own target date funds, robo advisors, or other pools of capital.
Despite some fits and starts along the way, the tides of history are clearly flowing in this direction.
Andrew D. Beer has over twenty-five years of experience in the alternative investment business. For over a dozen years, Mr. Beer’s singular focus has been to identify strategies to match or outperform portfolios of leading hedge funds with low fees, daily liquidity and less downside risk. He serves as the Managing Member at Dynamic Beta investments LLC (formerly branded Beachhead Capital Management) and is co-Portfolio Manager of the firm’s investment strategies.