The growing range of factor-based exchange-traded funds (ETF) could blow new life into hedge fund replication strategies.
The introduction of ETFs that gave exposure to volatility, liquidity and momentum would provide investors with low-cost ways to construct passive portfolios based on commonly-used hedge fund strategies, according to global provider of risk modelling and portfolio optimisation tools Axioma.
"Using factor ETFs, you can probably capture 80 per cent of hedge fund returns," Axioma Europe and Asia managing director Oliver d'Assier said in an interview with Investor Weekly.
D'Assier said that with the continuing innovation in the ETF industry, the gap between passive replication strategies and hedge funds had become increasingly smaller.
"What was missing in replication portfolios was strategy. Factor ETFs have the potential to close the gap," he said.
Tria Investment Partners managing partner Andrew Baker, who recently published a white paper on the state of the ETF market in Australia, said he would be unsurprised if factor ETFs made replication easier.
"Hedge fund replication often involves specialised beta exposures, such as small caps, and ETFs offer a relatively quick and liquid method of doing so," Baker said.
"Hedge funds cover a wide range of strategies, of course, but the emergence of ETFs over factors such as momentum, volatility, value, et cetera would certainly help."
In a 2006 paper, MIT professor Andrew Lo and research scientist Jasmina Hasanhodzic explained how hedge fund strategies could be replicated using low-cost, passive portfolios.
They argued one of the most important benefits of hedge fund investments was exposure to non-traditional types of risks, such as tail risk, liquidity risk and credit risk.
In an experiment replicating exposures to these risks, they found the return generated with these passive strategies accounted for around 80-90 per cent of hedge fund manager returns, while in some categories, including convertible arbitrage and global macro, the passive strategy replicated nearly identical returns.
Although they argued good hedge fund managers were likely to outperform these passive portfolios, the fee levels, lack of transparency, capacity limits and challenges of manager selection might make it more attractive for institutional investors to run clone portfolios.
In 2007, several managers, including Tyndall, Merrill Lynch and State Street, made efforts to introduce these models to the Australian market for institutional investors, but the global financial crisis cut short these attempts.
However, the introduction of increasingly specialised ETFs could see new efforts in this area.
Russell Investments is looking to introduce factor-based indices to Australia, which would pave the way for similar ETFs.
"Down the track it will be something that we will roll out here as well," newly-appointed Russell indexes Australia and New Zealand regional director Matt Wacher said.
Australia has just seen the introduction of the first factor-based ETFs, with the launch of high-yield instruments by several providers, including Russell, iShares, State Street Global Advisors and Vanguard, and it is expected this range will only expand in coming years.
State Street Global Advisors vice president Graham Smith said the use of ETFs globally had become increasingly more sophisticated, but he did point out the instruments were not built with the absolute return objective in mind that many hedge funds had.
Introducing such an objective would likely increase the costs of running a replication portfolio.
