Key Points:
- Many investment strategies offer exposure to the stock market in complex packages, leading to similar risk exposures across different products.
- An analysis of the iMGP DBi Hedge Strategy ETF found that a combination of the S&P 500 and cash could have replicated its performance with the same level of risk.
- Long-short equity hedge funds can be replicated with a portfolio consisting of the S&P 500 and cash, resulting in higher risk-adjusted returns.
- Factors such as survivorship bias and expense differentials make the replication portfolio more favorable compared to hedge funds.
- Investors can achieve higher returns through a simple S&P 500 and cash portfolio, highlighting the diluted equity exposure offered by hedge funds.
Introduction
Studies have shown that many investment strategies simply provide exposure to the stock market in complex ways, resulting in similar risk exposures. To illustrate this point, a tool called Time Machine was created to replicate the performance of various investment products using only the S&P 500 and cash. This article examines the replication of the iMGP DBi Hedge Strategy ETF and long-short equity hedge funds.
Replicating the iMGP DBi Hedge Strategy ETF
Using Time Machine, it was found that an allocation of 81% to the S&P 500 and 19% to cash would have achieved almost the same performance as the iMGP DBi Hedge Strategy ETF. This raises questions about the unique value proposition of this ETF.
Long-Short Equity Hedge Fund Performance
Long-short equity hedge funds aim to provide equity-like returns with less risk. However, the performance of these funds can be replicated using a combination of the S&P 500 and cash. The Eurekahedge Long Short Equities Hedge Fund Index and HFRX Equity Hedge Index were analyzed, with the latter considered more realistic due to survivorship bias. The replication portfolio achieved higher risk-adjusted returns compared to hedge funds.
Replicating Long-Short Hedge Funds
The volatility of the HFRX Equity Hedge Index was replicated using a 52% allocation to the S&P 500 and 49% to cash. The replication portfolio outperformed the hedge funds in terms of compound annual growth rate (CAGR) and drawdown, taking into account the additional costs associated with analyzing and investing in hedge funds.
Further Thoughts
While replication of investment products using the S&P 500 and cash may be viewed as hindsight analysis, the correlation between long-short equity hedge funds and the S&P 500 suggests diluted equity exposure. The replication portfolio offers a balanced exposure to rising and falling stocks. It is essential for investors to consider the potential benefits of simpler and more cost-effective investment strategies.
Disclaimer: The opinions expressed in this article are those of the author and do not necessarily reflect the views of CFA Institute or the author’s employer.
