New ETF Replicates Hedge-Fund Alpha
06/20/2012 7:00 am EST
Focus: ALTERNATIVE INVESTMENTS
AlphaClone’s new hedge fund, the AlphaClone Alternative Alpha ETF (ALFA), launched in late May, and has had a successful run-up so far. AlphaClone founder and CEO Maz Jadallah explains the index behind the fund, and how investors could consider using it.
Kate Stalter: Today, our guest is Maz Jadallah, founder and CEO of AlphaClone.
Maz, as I understand it, you had been noticing a few years back that individual investors really couldn’t get some of the returns of hedge funds. Obviously, there are minimum investment requirements, and also sky-high fees. So, talk about your business model and how you decided to begin addressing that.
Maz Jadallah: The main reason we built AlphaClone as a research platform in the first place—we launched in December 2008—was simply to give investors access that they didn’t have to arguably the best active managers in the world.
You know, even very, very wealthy investors don’t have access to every hedge fund out there. Not only because of the minimums, but also because of relationships. So most investors didn’t have access to these top hedge-fund managers.
Yet their public disclosures that they issue every quarter was a really very interesting insight into where they were actually investing their money, as opposed to what they were saying. And not that those two are necessarily very different; but still, it’s always good to see where someone’s actually putting their money.
So we built AlphaClone as a research platform that allowed you to construct strategies that followed these disclosures, and you can follow an individual manager or you can follow multiple managers. But that’s the basic premise of the platform and our research.
Kate Stalter: I want to talk about your ETF, but I want to follow up on the research for just a few moments. How do you select the managers you are tracking?
Maz Jadallah: We started with a list of 100 managers, really large institutional investors in hedge funds, and we let the data lead us into what types of managers really cloned the best.
And we found that, by and large, a couple of things: One is that fundamental-based managers tended to clone better than the sort of macro or quant-type hedge-fund strategies. So, fundamental, bottom-up, hedge-fund investors tended to clone the best. But that also, that, you know, different investment styles were favored at different times in the market, and that any manager could sort of get a hot hand, when followed, and then sort of underperform.
So, the key point there is that it’s really important to derive an objective way to continuously measure how an investor does following a manager. And we do that by doing something called a clone score that we repeatedly calculate for our investment manager universe, and we pick managers that have high clone scores.
Kate Stalter: So, segue then into the ETF, and the index that you’re using behind that ETF?
Maz Jadallah: Yeah, the index that underlies the ETF, ALFA, is the AlphaClone Hedge Fund Long-Short Index. And it really is an index of—they way to think about it is like a virtual fund of funds, really, without the, 3 and 30 fee structure, and we select managers in that index based on clone scores.
We recalculate clone scores every six months for every single manager in our universe. There’s over 330 managers in our universe, and we pick the managers with the highest clone score to go into the index. And, the index really represents where the “smart money” is allocating their dollars, when it comes to US-traded equities.
Kate Stalter: Now, there have been a few other ETFs in the past few years that have gotten started to model some kind of hedge-fund approach. How do you compare to some of these?
Maz Jadallah: Yeah, I think what you’re referencing are what they call factor-based replication ETFs. In a nutshell, what those try to do is take an index of hedge funds and recreate the statistical return qualities of the index—the volatility, the return characteristics, the skew of the index.
The problem with those products, I think, is that when it comes to indexes of hedge funds, the performance isn’t very good. You know, much like the private-equity world and the venture-capital world, in hedge funds it matters a great deal who you give your money to, whether it’s a top quintile manager or sort of a average manager—which is, by definition what an index represents—average performance amongst a group of managers.
So, I think you’ve seen those products not fulfill their potential. I think the good thing about our index is that it provides daily liquidity, but without having to give up the alpha potential that a hedge-fund investor wants in the first place.
Kate Stalter: I’m looking at a chart of ALFA right now, and obviously you just launched a few weeks ago, so it’s brand new. Thus far, in this particular volatile market we’ve had in the past few weeks, it has notched some nice gains during that time, as compared to maybe some flat trading or losses in some similar ETFs. What’s different?
Maz Jadallah: Well, you know, I think the fundamental difference is we’re investing direct. We’re the first index or ETF to invest directly in the disclosed equity holdings of hedge-fund managers. So, we’re doing what they call position replication, as opposed to beta factor replication. And a unique aspect of ALFA and the index is that it can vary from being long-only to essentially S&P 500 neutral or market hedged, depending on a very simple 200-day moving average trigger.
The reason we do that is because our research shows that we really want to be aligned with the market when the market is going up, because our horses tend to run faster than the market.
But sometimes it doesn’t matter how good of a stock picker you are or how good your algorithm is, you just need to be protected. And the dynamic hedge that we put on allows us to protect against multi-month drawdowns in the strategy, thereby protecting capital. So in that way, the approach is risk managed, and that’s why the index underlying ALFA is called the hedge-fund long-short index. It can be long or it can be market-neutral.
Kate Stalter: Let’s talk a little bit about how you envision investors utilizing this within their overall portfolio. Because as you know, most individuals, and even a lot of advisors, look just at equities or fixed income, bonds. How do you envision this fitting in?
Maz Jadallah: Well, I think there are two sort of no-brainers. One is: This is a better time to be exposed to US equities. Not only is it risk-managed, but we think that, following the disclosed positions of some of the most established hedge funds in the world, is a smart way to pick on the long side.
It’s a better way to get exposure to US equities, and also, because it’s risk managed—especially in this environment, this volatility—you really do want downside protection, especially when it’s over multiple months. You know, getting 10% or 15% drawdown is one thing, but getting a 30% to 40% drawdown is something entirely different, and very difficult to recover from. And that’s that latter case that we’re really looking to protect against.
The second sort of no-brainer use is, you know, is for hedge-fund allocators. People who invest in the hedge-fund category have really mandated since 2008 that a portion of that allocation be in liquid alternatives, because they don’t want to get caught short like they did in 2008.
Because of the lockups that are inherent in hedge funds, they couldn’t sell those positions, they had to sell other positions in order to finance their annual expenses. I’m talking about pension funds and so on and so forth. So, they’re mandating that there be liquid-alternative allocations.
The problem is: Products that provide liquidity have also meant that you needed to give up the alpha potential or the outperformance potential. And for us, our product, our ETF, is an opportunity for them to have that liquidity, but not give up the alpha potential.
Kate Stalter: Do you view this as an instrument that they should be holding throughout various market conditions, then?
Maz Jadallah: Yeah, I do. It’s risk-managed. This is a definite buy-and-hold approach to investing. It’s mindful of how to be positioned during market run-ups, and it’s mindful about how to be positioned during disruptive events in the market. So, it’s definitely a buy and hold.