Research

Exchange-traded funds (ETFs) have become an increasingly crucial tool for both institutional and retail investors to gain exposure to certain markets or hedge risks at a low cost in recent years. The explosive growth of the assets managed through ETFs has been largely driven by the increase in popularity of index funds, ETFs designed to track the performance of an index. An index fund could be used by retail investors to passively invest in equity markets, or by fund managers to easily adjust their portfolio exposure towards certain markets. The instant liquidity, transparency and low expenses of ETFs have been some of the primary advantages offered by ETFs over other types of investment vehicles such as mutual funds and hedge funds.

This section of the report focuses on a particular subclass of actively-managed ETFs created to replicate equity hedge fund strategies, drawing a comparison between these ETFs and their hedge fund counterparts. Such “hedge fund ETFs” allow retail and long-only investors to gain exposure to certain hedge fund strategies without investing through a hedge fund. However, ETFs which are also available to retail investors are typically subjected to stricter regulations such as limitations on investing in derivatives, employing leverages and short-selling assets, in contrast to hedge funds which are typically less restricted but available only to high-net-worth individuals and institutional investors. This raises the question of whether such investment restrictions and increased liquidity would affect the performance of alternative ETFs, relative to hedge funds employing similar strategies.

Figure 1 below provides a performance comparison between the Eurekahedge Long Short Equities Hedge Fund Index and the Eurekahedge Equity Market Neutral Hedge Fund Index against two composite indices representing several largest actively-managed ETFs employing similar strategies, as well as the underlying global equity market.

Figure 1: Performance comparison between equity hedge funds and alternative ETFs

Over the period starting from end-2014, long/short equity hedge funds and equity market neutral hedge funds have generated annualised returns of 3.33% and 1.47% respectively. On the other hand, actively-managed ETFs employing long/short equity and equity market neutral strategies have returned 0.64% and 0.22% per annum respectively, highlighting the performance disparity between the two investment vehicles.

Source: Eurekahedge

Table 1 provides the detailed risk return statistics of the hedge fund and alternative ETF strategies shown in the figure above. Key takeaways include:

1. Hedge fund managers utilising long/short equity strategies have lost 6.27% over the first four months of 2020, outperforming the global equity market as represented by the MSCI ACWI IMI (Local) which declined 13.16%. On the other hand, actively-managed long/short equity ETFs have slumped 21.96%, a loss exceeding what the global equity market suffered.


2. Equity market neutral ETFs have returned 0.79% as of April 2020 year-to-date, outperforming equity market neutral hedge funds which lost 2.56% over the same period. However, over the last five years, hedge fund managers utilising equity market neutral strategies have generated better returns than their alternative ETF counterparts.


3. Looking at annualised volatilities, both long/short equity and equity market neutral hedge funds have recorded lower volatilities compared to their alternative ETF counterparts. A similar observation could be made from the 5-year maximum drawdowns registered by these indices as shown in Table 1.

Table 2 provides the correlation matrix for the five indices shown in the table above. The performance of both long/short equity hedge funds and ETFs are strongly correlated to the global equity market, reflecting the common portfolio bias toward the long side among these funds. On the other hand, market neutral hedge funds and ETFs have recorded correlation coefficients of 0.60 and -0.43 against the MSCI ACWI respectively.

Table 2: Correlation matrix - equity hedge funds and alternative ETFs

Source: Eurekahedge

Table 3 provides the equity market beta exposure and excess returns of the hedge fund and ETF indices since the end of 2014. The Eurekahedge Long Short Equities Hedge Fund Index has recorded a beta of 0.49 against the MSCI ACWI IMI while delivering an excess return of 0.11% per month. On the other hand, the Long Short Equities ETF Composite has derived a bigger portion of its returns from market exposure, with a beta of 0.83 and excess return of -0.19% over the same period. Both equity market neutral hedge funds and ETFs have recorded significantly lower levels of Beta, while delivering similar levels of excess returns.

Source: Eurekahedge

Figure 2 provides the 12-month rolling Alpha of equity hedge funds and alternative ETFs against the underlying global equity market. ETFs utilising long/short equity strategies have generated increasingly negative 12-month rolling Alpha over the past year, an observation which falls in line with how their recent performance have trailed that of the MSCI ACWI in spite of their high Beta. On the other hand, equity market neutral ETFs have recorded strong 12-month excess returns around the end of 2019, which coincides with the period of time when their rolling Beta against the equity market turned increasingly negative. As of December 2019, the Equity Market Neutral ETF Composite had recorded a 12-month rolling beta of -0.79 against the MSCI ACWI.

Figure 2: 12-month rolling Alpha of equity hedge funds and alternative ETFs against the MSCI ACWI

While actively-managed ETFs provide an opportunity for retail and long-only investors to gain exposure to certain hedge fund strategies, their relative underperformance against hedge funds employing similar strategies over the long run could not be overlooked. Some of the advantages offered by ETFs, including instant liquidity and availability to non-accredited investors come with investment restrictions which limit the fund managers’ ability to generate profits. Another important thing to note is that the actively-managed ETFs comprising the two ETF composite indices analysed in this report have an average expense ratio of 1.49%, a level of fee which not only far exceeds those of most index funds, but also would not look out of place in the hedge fund industry. A brief look at the factsheets of these ETFs have also revealed that some of them invest in other ETFs, resulting in an additional performance drag from the multiple layers of fees which has also plagued the similarly structured fund of hedge funds industry. Based on this analysis, we believe that investors and fund managers looking to invest in alternative ETFs need to perform a thorough research on the underlying portfolios of the ETFs and the fund managers’ track record in actively-managed strategies.

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