Invest Like a Hedge Fund? Thanks but No Thanks!

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The Wall Street Journal recently featured an article, How Individual Investors Can Invest Like a Hedge Fund, that caught our attention. In light of recent poor performance which we have documented here and here, it is simply beyond us why anybody would want to emulate hedge funds. The authors themselves note that from the bottom of the market in 2009 through 6/30/2014, the S&P 500 Index is up 137% while the average hedge fund is only up 50%. Nevertheless, the authors identify three different approaches to achieving this questionable objective, which we will examine one by one.

The first method is called “hedge fund lite” which involves small investors accessing hedge fund strategies via “alternative” mutual funds. We recently wrote about the poor year-to-date performance of these funds in this article. To see if anything changed, we ran the year-to-date returns as of 7/31/2014 for the five main sub-categories of alternative funds, and not one of them came close to the 5.66% return of the S&P 500 Index. Not surprisingly, the worst of the categories was bear market funds which suffered a loss of 8.53%. The best category was long/short equity which clocked a gain of 1.81%. The authors note that although the alternative mutual funds don’t charge performance fees like hedge funds do, they charge high annual management fees that in some cases approach 4% of assets.

The second method of emulating hedge funds is called “replication” or “liquid beta”, and it involves running multiple regressions of hedge fund returns to determine the factors that explain those returns. This is similar to analyzing the historical returns of a long-only equity mutual fund to determine its exposure to the risk factors of market, size, and value. One company that specializes in hedge fund replication indexes is IndexIQ, and it has developed a stable of exchange-traded funds that replicate different categories of hedge funds. Their oldest such fund, IQ Hedge Multi Strategy Tracker ETF (QAI), now has five years of returns data. For the five year period ending June 30th, QAI had an annualized return of 4.11% while the S&P 500 Index came in at 18.82%, according to the fact sheet for QAI. QAI’s return even fell short of Barclays Capital U.S. Aggregate Bond Index at 4.85%.

The third method is called “copycat investing”, and as its name suggests, it simply involves simply imitating what is publicly known about the trading positions of hedge funds.  The authors note that hedge funds that have more than $100 million of public securities are required to file 13F forms with the SEC which discloses their largest stock positions. The forms must be filed within 45 days after the end of the quarter, and the forms are searchable on the SEC Website. Of course, any information that is 45 days old should have questionable value, regardless of what one believes about market efficiency. Another problem is that examining only long stock positions does not reveal what the hedge fund’s true underlying strategy is. For example, a long position in Facebook may be offset by a short position in Google. The authors also mention a related tactic of combing through the 13D filings of activist investors like Carl Icahn and Bill Ackman, but again, this would mean relying on stale information of questionable value.

To summarize, none of these three methods suggest a compelling case for individual investors to invest like hedge funds. The Wall Street Journal is home to other authors and columnists such as Jason Zweig who continually provide investors with sound and prudent advice. If you are currently a hedge fund investor and would like to learn about a better way to invest, please give us a call at 888-643-3133.