What is hedge fund replication?

by: , Chief Investment Officer and Managing Director | IndexIQ

There are many kinds of hedge fund strategies in the market. HFR, a leading hedge fund industry research group, tracks four major categories – Macro, Equity Hedge, Event Driven, and Relative Value – each with multiple sub-strategies focused on everything from stocks and bonds to emerging markets and credit arbitrage. And, of course, every fund manager will execute these strategies differently based on his or her own research and views of the market.

Regardless of the style of strategy or manager, the goal of a hedge fund is to, over time, deliver value, either in the form of excess return over the broad market, or in downside participation, or both. But traditional hedge fund investing is an expensive process, with a significant portion of returns lost to high fees. It exposes investors to a number of unknowns, including idiosyncratic manager risk – a concentrated bet that a single manager or group of managers will outperform the market. It’s illiquid. And, of course, it’s opaque – no hedge fund manager wants to fully reveal his or her investment process over concern they will lose their “edge.”

This is where hedge fund replication strategies come in. ETFs using replication seek to identify the key characteristics that drive performance and “replicate” them in a low-cost index-based fund. This approach is supported by a body of research that has generally found that systematic exposures to traditional and non-traditional asset classes is the broadest source of hedge fund returns, supplemented in some (but by no means all) cases by manager skill. The systematic component can be referred to as “beta” (where manager skill is “alpha”) and it’s that beta that most replication strategies seek to capture in a generally liquid, transparent, and low-cost way.

For example, a Long/Short Equity manager may own a group of securities long while simultaneously shorting a different group of securities. When you aggregate all of the holdings across multiple Long/Short Equity managers, you find that many of the “stock specific” effects diversify away (much like they do when you have a large group of stocks). You are left with a bunch of “factor” returns such as Large Cap equity vs. Small Cap equity, Value vs. Growth, US equity vs. International equity, etc. Managers trying to generate alpha may, by contrast, make more concentrated positions in an effort to outperform. But this outperformance is by nature difficult to achieve and, for most, non-recurring – how many managers “beat” the market year after year? Beta strategies may be less exciting, but historically they have provided more consistent returns.

Like hedge funds themselves, a replication-based fund may focus on a single strategy like Macro or Event Driven, or it may seek to capture the return of hedge funds as an asset class through a multi-strategy approach. These multi-strategy ETFs like QAI, the IQ Hedge Multi-Strategy Tracker ETF, seek to replicate and capture the beta of a broad cross section of the alternative investing universe including long/short equity, global macro, market neutral, event driven, fixed income arbitrage, and emerging markets. This is something like the returns reflected in the HFRI Fund of Funds Index. But that index includes hundreds of funds and is not investable. Replication allows a manager to pursue similar returns in an investable way.

As we’ve discussed in our recent blog, “Merger arbitrage strategies – a powerful tool to manage market volatility“, these strategies can play an important role in a portfolio, particularly during periods of market volatility like we’re currently experiencing. By design, they look to provide positive returns with less exposure to traditional sources of risk. With a multi-asset approach providing broad access to the hedge fund universe, they’re “hedged” in the true sense of the word. In the most recent ten-year period, from 2008-2017, multi-asset strategies were among the least volatile asset classes, with only minimal bouts of volatility above core fixed income. For investors who want to maintain exposure to the market while seeking to manage risk, these funds are worth considering.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

About Risk: QAI

Before considering an investment in the Fund, you should understand that you could lose money.

The Fund’s investment performance, because it is a fund of funds, depends on the investment performance of the underlying ETFs in which it invests. There is no guarantee that the Fund itself, or any of the ETFs in the Fund’s portfolio, will perform exactly as its underlying index. The Fund’s underlying ETFs invest in: foreign securities, which are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Leverage, including borrowing, will cause some of the Fund’s underlying ETFs to be more volatile than if the underlying ETFs had not been leveraged. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

The ETF should be considered a speculative investment with a high degree of risk, does not represent a complete investment program and is not suitable for all investors.

Alpha, a measure of performance, is the excess return of an investment relative to the return of a benchmark index.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

HFRI Fund of Funds Index is comprised of strategies that invest in multiple, diversified funds or managed accounts with the objective of significantly lowering the risk (or volatility) of investing with an individual manager.

Consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Fund and are available by visiting nylinvestments.com/etfs or calling 888-474-7725. Read the prospectus carefully before investing.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, New York 10010, provides investment advisory products and services. IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs, and NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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