Bernstein: How to Build Your Own Hedge Fund

[petrico]

From an interesting WSJ article on hedge fund characteristics and how to duplicate them at a tiny fraction of the cost:

"If you want, you can re-create hedge funds in a low-cost way," says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.

All told, up to 80% of the average hedge fund's returns can be explained simply by size, style and market beta, according to an analysis conducted for The Wall Street Journal by Mr. Bernstein.

According to Mr. Bernstein's analysis, investors can more or less replicate hedge funds with just a handful of low-cost ETFs containing the same essential nutrients—market beta, size and style.

The building blocks are simple: varying amounts of just two ETFs, plus cash. One ETF tracks the Russell 3000 index, which includes 98% of the U.S. stock market. The other includes the Russell 3000's "growth stocks"—companies with high prices relative to their "book value," or the total value of their assets minus debts.

Build Your Own Hedge Fund (Try Google if you don't have a WSJ subscription -- that's what I did.)

One question that came to mind after seeing a few representative portfolios is, who would want to invest like a hedge fund, anyway?

--Pete

[Johm221122]

I could not even finish this article this morning. I could not agree more ,why would I want too
John

[Boglenaut]

I just read the print copy at breakfast. I couldn't believe the amount of cash held.

[WendyW]

http://finance.yahoo.com/news/build-own ... 00776.html

[livesoft]

Read the article. The "build your own" was kinda a joke wasn't it? The idea was to replicate the poor performance of hedge funds in the last few years. One way to do that would be to have a lot of cash.

Why would anybody want to get the recent returns of hedge funds?

The next thing you know there will be an article about a new hedge fund: Vanguard Total Stock Market Index fund.

[Van]

I just finished the article. NO THANKS.

[Boglenaut]

I usually look forward to the Saturday edition's investing section. I was wondering why they bothered to print such a low quality piece. Really, this one made no sense at all.

I much preferred the article on Fidelity cutting ER's on Spartan funds.

[petrico]

I actually thought it was a good article, with an interesting premise: the returns of (most) hedge funds can be explained largely by the very same factors discussed here on a daily basis: size, style and market beta.

Providing a direct link to Bernstein's excellent article, Rolling Your Own: Three-Factor Analysis, was a plus.

Hedge fund fees are truly obscene (the real investment porn?).

And my flat-broke state recently paid the largest hedge fund in the world over $115M to help it move 13 miles into a huge new waterfront site in the city where our governor was the former mayor. Carried interest for income, corporate welfare... the 2% of assets and 20% of any profits are just the beginning.

--Pete

[allsop]

Agree with Pete here.

[dad2000]

Unfortunately, you can't replicate the 2+20% management fees into your pocket for creating the hedge fund

[wbern]

First off, Mr. Light deserves real credit for discussing multifactor regression in the WSJ. When was the last time you read about that subject in the Journal, let alone in a lesser mass-market publication?

Second, neither Mr. Light nor I recommended the replication strategy; it was simply a pedagogical tool to demonstrate how you could passively mimic the average hedge fund strategy at a tenth the cost with better results and much better liquidity.

The best way to persuade non-Bogleheads not to do stupid things like invest in hedge funds is not to hit them over the head with how dumb they are for doing so, but rather to show them just how much they're paying for nothing, and I think Joe's piece did a pretty good job of that.

Bill

[dkturner]

First off, Mr. Light deserves real credit for discussing multifactor regression in the WSJ. When was the last time you read about that subject in the Journal, let alone in a lesser mass-market publication?

Second, neither Mr. Light nor I recommended the replication strategy; it was simply a pedagogical tool to demonstrate how you could passively mimic the average hedge fund strategy at a tenth the cost with better results and much better liquidity.

The best way to persuade non-Bogleheads not to do stupid things like invest in hedge funds is not to hit them over the head with how dumb they are for doing so, but rather to show them just how much they're paying for nothing, and I think Joe's piece did a pretty good job of that.

Bill

When I read Mr. Light's WSJ article yesterday I had a deja vu moment.

I sit on the investment committee of an endowment with a substantial commitment to "diversifying equity" ("hedge fund" is so unsophisticated a term). We are advised by a very large international consulting firm which meets with our committee quarterly.

I had noted that for some time our 3 year performance consistently trailed our benchmark, while our 5 year performance was slightly better than benchmark. No mystery here. Our hedge funds lost considerably less than mainsteam equities from September 2008 to March 2009, but have been a drag on equity performance since the market bottom of March 2009.

In addition to our hedge fund allocation we also have a substantial allocation to the GMO "quality equity" style (see GQEFX for details). This GMO style invests in the largest, and bluest, of blue chip equities. Just prior to our October quarterly meeting I was reading our briefing book and noticed something that I hadn't focused on before, but was vaguely aware of. This "quality equity" performance also held up much better than mainstream equities during the 2008-2009 meltdown, but had dampened performance since mid 2009.

I dug out my March 2009 and March 2010 briefing books to see exactly what happened with our hedge funds compared to our "quality equity" in performance. Guess what. Hedge funds declined MORE than "quality equities" from 3/31/2008 to 3/31/2009, but bounced back LESS from 3/31/2009 to 3/31/2010.

In digging around on Morningstar I noticed that Vanguard has a Dividend Growth Fund (VDIGX) which is managed by Wellington Management and has exhibited a performance that is remarkably similiar to the performance of GQEFX.

Is there more than one way to skin a (hedge fund) cat or are you and Jeremy Grantham simply exhibiting slight variations of the same theme?

[wbern]

To repeat, I was in no way endorsing using a mix of Ru3000, Ru3000G, and cash; I was simply saying that doing so closely mimics hedge fund performance, with generally superior results and much lower costs.

I could also have said that investing in hedge funds could, in the long run, be closely approximated by burning half your money and throwing the other half out the window; I don't endorse that either!

Bill

[ofcmetz]

To repeat, I was in no way endorsing using a mix of Ru3000, Ru3000G, and cash; I was simply saying that doing so closely mimics hedge fund performance, with generally superior results and much lower costs.

I could also have said that investing in hedge funds could, in the long run, be closely approximated by burning half your money and throwing the other half out the window; I don't endorse that either!

Bill

I cringe at the amount my state pension fund invests in hedge funds.

Dr. Bernstein, thanks for educating us and for stating things so clearly.

Jeff

[Jerilynn]

Don't know about the rest of y'all, but I let Vanguard build my Hedge Fund.

[petrico]

To repeat, I was in no way endorsing using a mix of Ru3000, Ru3000G, and cash; I was simply saying that doing so closely mimics hedge fund performance, with generally superior results and much lower costs.

I could also have said that investing in hedge funds could, in the long run, be closely approximated by burning half your money and throwing the other half out the window; I don't endorse that either!

Bill

Thanks for weighing in here and confirming your perspective!

Unfortunately, the one hedge fund I'm curious about seems to be what you refer to as a "macro" fund, and thus difficult to analyze. Without getting into the question of whether this giant hedge fund will offer our little state -- which has resorted to paying its bills with a line of credit -- any "economic development alpha" ( ), is there any way to determine if Bridgewater has demonstrated positive alpha?

--Pete

[maddyken]

I'm not sure HFs are necessary.

I referred to the growth vs inflation model when I built my portfolio, I referred to many other things as well. While asset classes don't quite fit as neatly into that macro model as the diagrams show at minimum the model provides the rationale behind asset classes in terms of growth and inflation. (Risk factors are preferable to asset classes because they explain why classes behave as they do.)

HFs and managed futures are considered the only all-weather classes in the growth vs inflation model, although most presentations of the model ignore them. For practical reasons HFs and MFs weren't a real consideration for me, so I settled on exposure to many asset classes to give me coverage of the growth and inflation combinations without the need for the all-weather characteristics of HFs and MFs. While maybe not absolutely necessary HFs and MFs can improve portfolio diversification.

Comparing the performance of a HF to a combination of cash and a stock allocation based on the 3-factor model ignores the diversifying effects of the HF, although the head-to-head comparison might be useful if one were contemplating investing everything in a single hedge fund. HFs are an asset class just like TIPS, completely investing in a single asset class requiring special circumstances.

[baw703916]

This thread inspired me to look up how the Bogleheads Hedge Fund Contest is doing.

My fund is up 12% this year. More to the point, I could have collected 4.4% in fees had this been a real fund.