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Liquid alternatives and hedge fund replication have always loomed as a massive white space for the ETF industry. Investors have more than $2 trillion invested in traditional hedge funds, often paying huge fees for the privilege and getting middling results in return. Swashbuckling ETF entrepreneurs have eyed it with envy, convinced they can deliver similar returns at a fraction of the cost.
On Wednesday, January 24, at the Inside ETFs conference, Yasmin Dahya—head of the Americas Beta Specialist team at J.P. Morgan Asset Management—will give a talk titled, “Beating Hedge Funds at Their Own Game: Alpha & Beta Separation Comes to Hedge Funds.” In anticipation of the talk, Inside ETFs CEO Matt Hougan sat down with Dahya recently to discuss hedge fund ETFs and why right now is the moment for liquid alts to shine.
Matt Hougan: Let’s start with the topic of your talk. I’ll ask the question straight out: Can you beat hedge funds at their own game?
Yasmin Dahya: Our products are not really aimed at beating hedge funds; instead, we’re trying to democratize access to the hedge funds space.
The problem many investors face today is they need new ways to diversify their portfolios. Hedge funds have always been a good diversifier, but they’ve come with two major flaws: First, many come at a very high cost; and second, many investors can’t access them due to the funds’ high minimums and long lockups. Our alternative beta suite aims to deliver the systematic drivers of hedge fund returns in a liquid, low-cost manner.
We’re not new to this: Since 2009, we’ve been delivering attractive risk-adjusted returns with a low sensitivity to traditional markets. Said another way, we’ve been able to deliver the value associated with hedge funds but at a much lower cost.
MH: Delivering the value of hedge funds at a much lower cost … isn’t that beating hedge funds at their own game?
YD: I think it comes back to the idea of alpha and beta. We’re not saying that alpha doesn’t exist. We’re just saying that, like the systematic portion of the equity market that can be captured with factor-driven strategies, there’s also a systematic portion of the hedge fund market that you can access with factor-driven strategies.
It’s not about beating hedge funds. It’s about the desegregation of alpha and beta.
MH: What kind of hedge fund strategies can be captured in an ETF?
YD: Our core hedge fund ETF—the JPMorgan Diversified Alternatives ETF (JPHF)—captures three key hedge fund strategies: equity long/short, event-driven and managed futures. Together, these three strategies encompass approximately 80 percent of the total hedge fund universe.
There are segments of that universe that you can’t capture in an ETF: Illiquid strategies like distressed credit or highly leveraged strategies like fixed-income arbitrage don’t lend themselves to ETFs.
But for 80 percent of the market, you can use factors to take a systematic view.
MH: What kind of returns can investors expect?
YD: Our portfolios are long/short portfolios diversified across the three core hedge fund styles, and our goal is to deliver attractive risk-adjusted returns compared to traditional asset classes.
One thing that’s critical about our strategies is that they should deliver returns regardless of the economic or market regime. Some factors are cyclical, and as a result of that, some factor-based ETFs will prove to be cyclical as well. But our strategy invests across 19 different factors and four different asset classes, and is long/short in nature, which helps it be regime-independent.
That’s critical right now. We actually think the value proposition for alternatives in general, and our strategies specifically, is stronger now than at any point in the near past. In the kind of market we’re facing today, with high equity valuations and a potentially challenging market for bonds, finding ways to diversify away from traditional asset classes is critical. Our liquid alternatives let you do just that.
MH: How should investors evaluate and compare different alternative strategies?
YD: Just like in strategic-beta equity ETFs, there are huge differences in product construction and how managers apply factor-based investing strategies in the alternatives space.
First and foremost, I would look at the research process and the experience of the manager; experience matters a lot in this space.
Second, I would look at how the manager approaches portfolio construction, and particularly how they deal with concentration risk. Our portfolio construction emphasizes diversification across key dimensions including regions, sectors, stocks and asset classes, and that helps us deliver a more balanced capture of the underlying factor exposures.
Finally, how a manager approaches cash management is key. Because most alternative strategies are long/short strategies, deciding how to fund those longs and shorts—and making sure your collateral can withstand market volatility—is critical. You need to look for managers that keep sufficient cash in the portfolio to cover any issues, examining both current cash positions and cash positions over time.
MH: You mentioned your strategies are factor-driven. What factors do you target?
YD: We target 19 different factors across our portfolios. In equity long/short, we look at value, quality, momentum and size across multiple different markets. In our event-driven portfolio, we invest across six different factors, such as merger arbitrage. In managed futures, we look at carry and momentum across all different asset classes.
MH: Hedge funds haven’t gotten much good press recently. Why should someone be interested in these products?
YD: Over the past nine years, people haven’t necessarily needed a hedged strategy in their portfolios, because the market has gone straight up. When you compare hedge fund returns to the market return in a low-volatility bull market environment, the value prop for hedge funds looks weak.
But for that very reason, I think now is a good time to be looking at this space. The value of finding a diversified source of return in your portfolio—particularly given equity valuations and the challenges facing the bond market—is pretty high.
We think the recent push by investors towards low-cost products will continue. But we think those investors will start to look for both low-cost products and differentiated returns. That creates the perfect environment for liquid alternatives going forward.
MH: Who is buying your funds?
YD: There’s a wide array of investors using our portfolios, but I’ll give you three key examples.
One example would be asset allocators looking to diversify their portfolio and adding this exposure as a replacement of or a complement to existing hedge fund exposures. Another example would be ETF-only investors that see this as the first easy way to get alternative exposure into their portfolios. The last group is people using this as a one-ticket solution for diversified alternative exposure, and using it particularly for smaller accounts.
MH: Alternatives are massive, but alternative ETFs are not. What would it take for alternative ETFs to become a $100 billion market?
YD: Our ETFs are factor-driven products, and I think they face a similar challenge to the one faced by strategic-beta ETFs.
There’s a great deal of demand for core education: what the factors are, how they work and so on. But a big piece of it is also getting technology tools into the hands of advisors so that they can understand the factors they have in their current portfolios. It’s hard to convince investors to allocate specifically to new factors when they don’t know what factors they already have in their portfolios. We’re seeing progress along those lines, and we’re investing heavily in it, but there’s still room to go.
Matt Hougan is the CEO of Inside ETFs. Inside ETFs and Wealthmanagement.com are both owned by Informa Plc.