Morningstar Advisor - Spring 2007 - (Page 31)

strategies and managers, only the investor doesn’t have to pony up a performance fee. And indexes usually provide better liquidity than funds of funds, pricing NAVs weekly, rather than monthly. Performance has been a problem for most investable indexes, however, and almost none have been able to match the returns of their non-investable counterparts. Costs are a big reason: Investable indexes usually charge an expense ratio of 1%, which is a significant hurdle for a vehicle whose gains tend to range in the single digits. The bigger challenge has been representation. First, hedge fund indexes are only composed of funds that choose to report their returns. This leaves out sizable players, because some of largest and best-performing hedge funds don’t make their returns public. There’s the added caveat that most investable indexes can only put money to work in funds that are open to investors—yet the funds that are closed are often among the best performers. Again, index investors won’t be able to participate in those returns, making adverse selection an unavoidable stumbling block. The good news is that methodologies are frequently revised and reinvented to make up for some of the gaps. Royal Bank of Canada, for example, casts a wider net than most indexes and includes 250 funds in its RBC Hedge 250 Index. It also sets high standards for the funds in which it invests. Those changes have produced some encouraging results so far, but the jury’s out on whether it can continue to thrive. Down the road, the brave new world of structured products and ETFs might be where to look for the innovative and effective passive investment. There are already a plethora of low-cost fundamental indexes and ETFs available, and some investors are choosing to assemble these to construct their own virtual hedge fund portfolio, taking full advantage of their low cost and liquidity. The recently launched Clear Spin-Off Index CLRSO, for example, invests in stocks that were spun off from other companies—a common strategy used by hedge fund managers. Meanwhile, PowerShares Buyback Achievers Index PKW buys companies that have above-average buyback programs in place. Admittedly, these funds only cover select niche strategies, but they are growing in number and in scope and are apt to provide stiff competition for costly hedge funds that ply basic strategies. There are some broader, more-ambitious products in the hopper, too. Goldman Sachs’ soonto-be-launched Absolute Return Tracker (ART) Index plans to replicate hedge fund returns by buying and selling baskets of securities, ranging from stocks and bonds to indexes and ETFs. Based on the notion that hedge fund strategies are tied to certain risk factors, such as credit spreads or volatility, that are easily replicable in the open market, Goldman is hoping its index will give investors cheap and liquid access to conventional hedge fund strategies. The main lure here is that investors may be able tap into what’s known in hedge circles as “hedge-fund beta” in one fell swoop, without being subject to liquidity restrictions and lofty fee structures. As exciting as that sounds, Goldman will need to prove it can update its portfolio at the same pace that hedge-fund managers do. While these new products may not produce the same kind of sea change in the hedge fund world as index funds and ETFs have in the long-only domain, at least they will help to shed light on whether hedge fund managers are really earning those lofty fees they love to charge investors. If a strategy is easily replicable, why should an investor pay up when they essentially access it through a more-cheaply priced ETF or structured product? K The Field Is Thin, But These Options Hedge The Merger Fund MERFX Mutual fund employs straightforward merger-arbitrage strategy. Diamond Hill Long/Short DIAMX Mutual fund uses conventional long/short strategy with a contrarian tack. Hussman Strategic Growth HSGFX Mutual fund uses options on indexes to both hedge and leverage. RBC Hedge 250 Index Investable index contains an unusually high number of hedge funds. Clear Spin-Off Index CLRSO ETF invests in stocks that were spun off from other companies. PowerShares Buyback Achievers Index PKW ETF buys companies that have buyback programs in place. Goldman Sachs Absolute Return Tracker Index Index tries to replicate hedge fund returns by trading baskets of securities. Gareth Lyons is a hedge fund analyst with Morningstar. MorningstarAdvisor.com 31 http://morningstaradvisor.com

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Spring 2007

Morningstar Advisor Spring 2007 Features Departments Letter from Joe Mansueto Get to Know Morningstar’s Fund Managers of the Year Is Your Client a Stock or a Bond? Less Alpha, More Beta Than Meets the Eye Your Mileage May Vary A Clear-Eyed Look at Hedge Funds Lower Risk, Higher Returns, What’s Not to Like? Without Cash and Clout, Advisors and Clients Get Short End of Stick Get the Strategy Minus the Headaches Analyzing Funds of Hedge Funds Not All Hedge Funds Are Created Equal A Fund with a (Long) View Laying Low and Prospering A Menu of Ideas to Fill Five Market Baskets Oil and Gas Gushing with Values Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web You Can’t Always Get What You Want

Morningstar Advisor - Spring 2007

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