The main question of an investor is the asset class to invest in and its respective weighting. The first dilemma comes with the approach to follow regarding the allocation: active (smart alpha via hedge funds) or passive (smart beta via ETFs). Investing in traditional indices is substituted by ETFs, a 25-year market with increasing popularity, which attracts $3 trillion and overtook the long-standing hedge fund industry in terms of assets under management in Q2 2015.
Starting from the accessibility of the two alternative classes, ETFs attract the whole spectrum of investors in contrast to hedge funds, which can be accessed only by accredited high net worth individuals and institutional investors and require a high minimum investment amount. Clearly, the current prevalence of ETF’s class over hedge funds is explained by their target investors’ group and not by performance criteria or the higher fees charged by hedge funds.
Fees charged by the active hedge fund managers are much higher than the respective of ETFs, which are justified by their sophisticated investing techniques and their tailor-made solutions. Hedge funds apply complex methods and occupy a lot of analysts to provide investors with alpha generating opportunities through a thorough glance and analysis at the markets. The remuneration package includes all these costs as well as motivation fees for aligning managers’ interest with those of investors. What investors actually pay though is the ability of hedge fund managers to apply active market timing and profit maximizing moves through capital preservation.
The smartest idea that arises from the above analysis could be an ETF replicating hedge fund strategy. The question is if this could be possible given the lack of information disclosure in hedge funds’ portfolio holdings; hence a direct replication through being long and short in underlying assets is inapplicable. There are ETFs mimicking hedge fund strategies and indices, but this apparently cannot produce similar performance to those of skilled active managers, but only of the whole spectrum of hedge funds.
Investors, before joining the recent ETF stampede, should base their investing decisions on their investment horizon. More investors translate to higher trading volume and intraday volatility as prices, in contrast to other mutual funds, are changing continuously throughout the day, introducing emotional effects and irrational decisions into a well-designed strategy. Additionally, the periodic rebalancing applied from smart beta strategies ignores market changes leaving investors exposed to distressed companies.
After the analysis concerning the idiosyncrasies of both asset classes, inevitably discussion should arise concerning their performance. The author’s perspective does not consider this comparison robust due to differences in their strategies and objectives. For this perspective’s case, a simple presentation of performance in term of returns and volatility is conducted, without suggesting basing investment decisions on the figures below.
Alternative investments and especially hedge funds produce uncorrelated to traditional investment returns which do not follow normal distribution, leading to unreliable conclusions. The dynamics of the applied hedge funds’ strategies and the serial correlation that may arise in the returns highlight the need for considering higher moments in distribution because Sharpe Ratio is heavily affected and underestimating the actual risk. For the purposes of this perspective, drawdown and Calmar ratio are used in order to access their differences in terms of performance.
Calmar Ratio = Compounded Annualized Returns / ǀMaximum Drawdownǀ
This perspective suggests thorough diligence and research on managers that produce robust returns with long standing track-record and constantly outperform the indices. There are skilled managers that apply smart strategies and are able to identify opportunities that other smart strategies cannot. While, no one can declare a clear winner, this perspective tips the scale in favor of hedge funsds.
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