How a Basket of ETFs Mimicked the Performance of Top Hedge Funds

Research shows how allocators can benefit from the thinking of top managers, without the high costs and other downsides.

Illustration by II

Illustration by II

The best investment ideas of billionaire hedge fund managers could be available in one cheap fund.

Actually, it’s better than that. Eight years of evidence now shows that investors can outperform the top institutional hedge funds by investing in a basket of exchange-traded funds. The basket also had a higher Sharpe ratio and lower maximum drawdown than the top funds — as represented by an index — that it tracks. Markov Processes International (MPI) said the basket outperforms because it avoids the higher fees of hedge funds and the performance snags that come from issues with operations and redemptions.

The conclusions are a fresh addition to the debate over the costs, complexity, and risks of institutional investors’ asset allocation models and portfolio construction — and the often-disappointing outcomes of these approaches. Former consultant Richard Ennis has argued that allocators would be better off using a simple portfolio of stocks and bonds, rather than the complex endowment model. Other managers have turned in evidence that there are cheaper and more transparent strategies than single manager hedge funds that investors can use to protect their portfolios. Asset manager Dynamic Beta, for example, uses hedge fund replication to outperform many elite managers. If the performance of the best hedge fund managers can be mimicked by a cheaper fund, why invest in less liquid and more complex products?

“There is a lot of value in hedge funds, but also some risks — individual headline risk, not being diversified enough. But if you put them together correctly you can capture their collective knowledge,” Michael Markov, founder of MPI, told Institutional Investor.

The basket — or tracker — grew out of an effort to build what it thought would be a better benchmark. Some commonly used ones, such as those from HFR, included thousands of funds. Hedge fund research and analytics firm PivotalPath created its own composite to combat the problem, deliberately designing the index to include only institutional-quality funds.

Eight years ago, MPI first developed the Eurekahedge 50 Index, which represents the 50 largest hedge funds across five strategies. Among other things, the index only includes one fund for each manager, to prevent the concentration of risk in any one firm. The benchmark was designed to reflect an institutional investor’s diversified portfolio of hedge funds. Investors use benchmarks as yardsticks to evaluate the risk, returns, and other characteristics of their portfolios — or individual asset classes — over time.

MPI then created a basket of exchange-traded products to track the benchmark. MPI used its own version of returns-based style analysis, to capture the big-picture bets of the 50 hedge fund managers, without knowing confidential position information. According to MPI, “the index represents a group of highly desirable institutional quality funds that are “hard to get in or out.” The combined assets under management of the funds in the index was $206 billion, with an average minimum investment of $7.6 million. In fact, 11 of the 50 funds are closed to new investors and only allow quarterly or annual redemptions.

In backtests, the tracker also outperformed the benchmark on an annualized basis from January 1, 2009 to June 30, 2022. The tracker delivered 8.28 percent on an annualized basis, compared to the benchmark’s return of 6.94 percent. The benchmark had a Sharpe ratio of 1.23, with the tracker having a Sharpe ratio of 1.36. The maximum drawdown of the 50 funds in aggregate was a loss of 11.33 percent. The tracker’s maximum loss was 9.06 percent.

Markov said the eight years of data also shows just how low volatility hedge funds can be. The volatility of the tracker is 5 percent. “That’s low even for hedge funds,” he said. That statistic reflects how diverse hedge fund bets can be and how quickly they can move, he said. “It’s a lot faster than stocks because stocks can’t go short. You can’t go short a factory or warehouse. When you put together a portfolio of 20 to 30 hedge funds, you end up with a very low vol portfolio.”