3 ETFs for Hedge Fund Replication

06/08/2015 10:00 am EST

Focus: ETFs

Highland Capital has just launched a trio of new exchange-traded funds which fall in a category called hedge fund replication ETFs. Here, Ethan Powell, chief product strategist at Highland Capital Management, explains how these niche funds work and discusses the specific strategies behind each of the firm's three new ETFs.

Steven Halpern:  Joining us today is Ethan Powell, chief product strategist at Highland Capital Management.  How are you doing today, Ethan?

Ethan Powell:  Steven, I’m doing very well.

Steven Halpern:  Highland Capital has just launched a trio of funds which fall in a category called hedge fund replication ETFs.  Before we look at the individual ETFs, could you first explain what is meant by Hedge Fund Replication?

Ethan Powell:  Sure, Steven, and thanks for having me here on MoneyShow today. Hedge fund replication strategies are simply ETFs that use a passive strategy to replicate hedge fund performance.  

There’s approximately $2 billion in these alternative strategies in the ETF wrapper, with a quarterly growth rate of 200 million, and until now, they’ve largely fallen into one of two categories: those that use factor-based replication in order to mimic hedge fund performance and then those that use 13F, or SEC filings, to mimic hedge fund performance.

And just to describe what those are; the factor-based replication attempts to replicate the hedge fund return by choosing different market factors and doing linear regression on historical data. And then they try and position the portfolio using ETFs or other index-based products, similar to hedge funds based on what those market factors might indicate.

And the challenge there is, you’re missing out on the ability of hedge funds to generate alpha through superior security selection because you’re just getting index exposure and it presumes that (a) you’re picking the right factors that influence the hedge fund’s positioning in the past and (b) that the historical relationship of those factors that actually showed some causality persist going forward.

And then, the second type is the 13F filers, so these guys effectively pull the 13F filings, which are the large holdings from hedge funds to the SEC.  The challenge with that is, they’re only filed on a quarterly basis with a 60-day lag, so you can have almost a five-month lag associated with those holdings before they’re incorporated in the portfolio.

And then, these are generally long only so you’re not getting the benefit of market exposure management or asset class allocation that hedge funds generally employ as well to deliver alpha, so that’s a general backdrop of these hedge fund replicating ETFs.

Steven Halpern:  So, now, your ETFs aren’t restricted in the same way that the factor-based strategies are or limited along the lines of the 13F filings.  How do yours differ from these two formats?

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Ethan Powell:  You know, what we’ve tried to do is, basically, tried to incorporate both elements of these two types of replications into a single solution.

So we are capturing the market exposure management, the tactical asset allocation capability, as well as the superior security selection, so all three levers that hedge funds basically have at their disposal to generate alpha.

That’s what we’re attempting to capture and how we’ve done that is, Highland Capital—we’re a $21 billion asset manager and $15 billion of our assets are in institutional accounts including hedge funds and then we’ve got approximately $6 billion in registered funds—so we’ve had 20 plus years of experience as a hedge fund sponsor and we’ve partnered up—or collaborated with—HFR.  

HFR stands for Hedge Fund Research.  They are the preeminent provider of hedge fund indices.  They’re best known for the HFRI and HFRX series of indices and they’ve been running those indices as well as providing the industry with hedge fund research for other 20 years.

And what we’ve done with them is—the HFRX actually has underlying separately managed accounts that have between 50 and 100 different hedge funds contributing daily positions to those separately managed accounts—and HFR has created the HFRL, which is a liquid HFR index that effectively samples those accounts to between 70% and 80% of the market value.  

It rebalances on a monthly basis, but intra-period, they are evaluating net market exposure and adjusting the HFRL market exposure based on the underlying SMA’s market exposure, so we’re capturing that ability to tactically manage our market exposure and what they’re sampling isn’t indices or broad-based equity exposure.  

It’s actual individual positions, so similar to the 13F filers, we’re able to capitalize on some of the best individual security selection ideas across the hedge fund universe in hopes that it represents more of a hedge fund market consensus versus specific hedge funds that may be trying to generate alpha through, you know, security selection, so that—at a high level—is how we differ from the existing strategies that are in the ETF wrappers.

Steven Halpern:  So, let’s briefly walk through the three new ETFs that you’ve launched and first let’s take a look at Highland HFR Global with the symbol (HHFR).  Could you explain the potential benefits and goals of this fund?

Ethan Powell:  Sure, so if you look at the HFR taxonomy of hedge fund strategies, the HFR Global represents the very highest level, so what that means is it looks a lot like a multi-strategy hedge fund and incorporates, sort of, the four sub-strategy disciplines of event-driven, long-short equity, macro, and relative value within the portfolio.

And, with all of these strategies, we’re looking to have equity exposure with muted volatility and how the multi-strat—or the HFR Global does that—is through both going long and short equities, but also incorporating fixed income commodities and currencies to help mute volatility as well as provide a non-correlated return stream relative to domestic equities.

Steven Halpern:  The second ETF you’ve launched is the Highland HFR Event-Driven ETF with the symbol (DRVN).  What differentiates this fund?

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Ethan Powell:  Sure, and here we’ve got a strategy that is one of the main sub-strategies under the HFR Global, but the event-driven strategies generally try to take advantage of specific, one-time events.

This can be anything from a corporate merger, a restructuring, financial distress, picking up some stressed and distressed securities, tender offers, anticipated share buybacks, or debt exchanges.  It really runs the gamut, but the one over-arching element is that there’s a near term event that the underlying managers believe will be a catalyst for reevaluation.

Steven Halpern: Now, can you tell our listeners about Highland HFR Equity Hedge ETF with the symbol (HHDG)?

Ethan Powell:  Sure. This is a traditional, long-short equity strategy that represents a fund that can obviously both go long equities—international as well as domestic—and short equities to manage market exposure.  

The expectation here is that the short book, while it will have some broad-based index shorts, still samples from the HFR SMAs to identify specific shorts that the underlying contributing managers believe will be devalued in the near term due to an event that is going to be a catalyst for that reevaluation, so again, muted equity volatility and a non-correlated return stream.

Steven Halpern:  Finally, in terms of a risk profile or an investor’s time horizon, what type of investor is best suited for these funds?

Ethan Powell:  You know, these funds really represent a—as I mentioned—muted equity exposure, or in some cases, if people are looking to avoid potential rate volatility in the fixed income markets, it’s a good alternative for that, in that you can still participate in the markets but not be subjected to potential rate volatility that might devalue the principal protection component of your portfolio.  

If you look at the HFRX and the HFRI historical return profiles, what you’ll see there is—depending on which strategy you’re looking at—that either half or to a third of the annual volatility of the S&P 500 with roughly a half of the performance or more depending on the market environment.  

I will say that if you’re looking at some of these historical return profiles, over the last five years—since the market troughed in 2009 and the S&P 500 has returned over 200% in the last five years—what you’re going to see is a broad-based beta rally for, really, all the risk assets and these particular hedged portfolios will generally underperform in that scenario.

But what we see in the marketplace today, Steven, is that a lot of investors are becoming more wary of the uncertainty and risk assets and believe that there may be a sideways trending, volatile risk asset environment and—if that’s the case—this is a great way to still participate in the markets while removing some of the volatility and not having that long-only exposure to risk assets.

Steven Halpern:  Again, our guest is Ethan Powell of Highland Capital Management.  Thank you for taking the time to share your insights today.

Ethan Powell:  Thank you, Steven.

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