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2015: How To Make Money In This Lousy Year

It is turning out to be a tough 2015 for stock market investors. The U.S. S&P 500 is trading where it was back on March 31. Fundstrat’s Thomas Lee recently noted that this has been only the second time since 1904 (!) that the S&P 500 has closed the first two quarters of the year with 0% gains. The one strategy that has made diversification look bad over the past five years – staying “dumb and long” in the U.S. stock market – has also run out of steam. There seem to be few other alternatives. After all, the Chinese market crashed, just as I predicted . And who knows how low it would really be if most of the stocks on the Shanghai exchange were actually trading. And back in the United States, even formerly red-hot bullish sectors like biotechnology and cybersecurity have petered out. So What’s Worked in this Market? I follow a lot of different investment strategies, often through various “smart beta” strategies I invest in both personally and on behalf of my clients. Among these strategies, only a few have generated satisfying returns. The First Trust IPOX Index ETF (NYSEARCA: FPX ) is up 9.34% in 2015. And that’s thanks largely to the strong performance of Facebook (NASDAQ: FB ), up 20.7% this year, in which FPX has an 11.86% weighting. The AlphaClone Alternative Alpha ETF (NYSEARCA: ALFA ) has also performed reasonably well, up 6.47%. Among asset classes, private equity is having a solid year, with PowerShares Global Listed Private Equity ETF (NYSEARCA: PSP ) up by 10.28%, boosted by its 8.56% yield. Tough Time for Hedge Funds The smart money across the globe is faring no better. As an average, hedge funds aren’t having a terrible year. But it’s nothing to write home about. The average hedge fund has been up 3.36%, according to Barclay Hedge, while the S&P 500 was up 3.25% over the same time period. But that average hides a multitude of poor performances among the biggest names in the business. Although not technically managing a hedge fund, Carl Icahn, hailed in 2013 as Wall Street’s richest investor, has seen shares in Icahn Enterprises (NASDAQ: IEP ) tumble 12.7% this year. Hedge funds in my neighborhood of Mayfair in London are having a tough time, as well. Odey Asset Management, one of the few remaining “old style” non-institutionalized hedge funds, is down 14.8% after a handful of concentrated bets in small-cap stocks have gone south. The dirty little secret of hedge funds is that most of today’s trading is done by computer. The algorithms of the rocket scientists have squeezed out every last bit of alpha, or superior risk-adjusted returns, in the market. You see that in the performance of trend-following hedge funds, also known as managed futures or commodity-trading advisors, which just suffered their worst month since July 2008 by falling 2.4%. In my view, the only way to make money in this market is “the old fashioned way”: bet big, swing for the fences and hit the lottery (to mix not just two but three metaphors). And that recalls one of my favorite quotes about old style hedge fund investors: “Some people are born smart. Some people are born lucky. Some are born smart enough to be lucky.” And in today’s market, it’s better to be lucky than smart. Buffett’s Lousy Year While the latest round of articles predicting Berkshire Hathaway’s (NYSE: BRK.A ) (NYSE: BRK.B ) imminent demise have yet to appear, Warren Buffett is having a lousy year, with Berkshire shares down 6.28% in 2015. That trails the Standard & Poor’s 500 index, which has gained a mere 1.55%. All of this has analysts scratching their heads. After all, Berkshire trades for less than 1.5x its book value. Barclays has a price target of $259,500 on the stock – 22% above current levels. And after all, Buffett has a reported $16 billion profit on the Heinz and Kraft private equity deals during the last two years. So why the lack of love for the stock? Well, Berkshire’s four largest and highest-profile publicly traded stocks aren’t doing too well. Among American Express (NYSE: AXP ), Coca-Cola (NYSE: KO ), IBM (NYSE: IBM ) and Wells Fargo (NYSE: WFC ), only Wells Fargo has beaten the S&P 500 over the past three- and five-year periods. IBM is worth less than Berkshire paid for it and has lagged behind the S&P by 60%. Coke is still below its 1998 peak. Here’s another irony. My top Buffett clone – Markel Corporation (NYSE: MKL ) – a recommendation in my Alpha Investor Letter newsletter, is hitting the ball out of the park with an investment strategy closely modeled on Buffett’s. And Markel is up a remarkable 28.33% in an otherwise ho-hum 2015, outperforming its model by close to 35% over a mere six months. So how is that for confusing? Psychology: The Small Investor’s Only Real Edge Truth be told, times like these are my favorite times to invest. With CNN’s Fear and Greed Indicator standing in single digits at a mere 7 , this is as close to an ideal time to put my own money to work as I am likely to find (though the index did hit “0” last October). In the absence of infinite gobs of computer power, and with a strong personal aversion to risking too much on any single idea, my only sustainable edge on this market is psychology. That’s why over the years, I’ve trained myself to gain distinct pleasure from investing against Mr. Market’s mood swings. And having had a chunk of cash just waiting on the sidelines, I just invested in several of the worst performing and technically oversold investment strategies in my own 401(k). Will I have caught the bottom of the market? Maybe… or maybe not. But I’m expecting the bets I placed yesterday to be profitable by the end of 2015. Disclosure: I hold FPX, ALFA, PSP, IEP, BRK.B and MKL.

Highland Capital Launches 3 Hedge Fund Style ETFs

Dallas-based Highland Capital Management is expanding its presence in the ETF world with a focus on alternative investing. Early this year, the issuer filed for 17 alternatives ETFs all targeting four broad hedge funds styles – equity hedge, event driven, macro and relative value. The successful debut of these funds will make Highland one of the largest managers of alternative ETFs in the market. Out of these, Highland Capital recently rolled out a trio of products that aim at giving investors new options in the hedge fund space. The three funds – the Highland HFR Global ETF (NYSEARCA: HHFR ) , the Highland HFR Event-Driven Activist ETF (NYSEARCA: DRVN ) and the Highland HFR Equity Hedge ETF (NYSEARCA: HHDG ) – are designed in collaboration with HFR and are the first of their kind to replicate hedge fund positions in an ETF. The trio provides global hedge fund exposure by investing in equity and debt securities of the U.S. and international companies, charging investors 85 bps in annual fees. The introduction of these ETFs quadrupled the size of Highland Capital’s ETF lineup. HHFR in Focus This ETF seeks to tracks the HFRL Global Index, which uses all the four hedge fund strategies to select the stocks. These strategies may include event-driven, long/short equity, macro, relative-value and other strategies commonly used by hedge fund managers. DRVN in Focus This fund looks to target the stocks of event-driven strategies, which take advantage of transaction announcements and other specific one-time events. The strategy then utilizes an investment process that identifies equity opportunities in companies which are currently engaged in a corporate transaction, such as mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. The ETF seeks to track the HFRL Event-Driven Index. HHDG in Focus This fund follows the HFRL Equity Hedge Index, which measures the performance of stocks based only on equity hedge strategies that combine long holdings of equity securities with short sales of stock, stock indices or derivatives related to equity markets. How Do They Fit in a Portfolio? The new products appear interesting choices for investors seeking some smart stock-selection techniques to avoid risks in the market. Hedge-fund replication ETFs have been gaining immense popularity in recent years as these seek to outperform the market over the long term. The funds try to either replicate the investing styles of renowned investors or mimic an index that aims to provide specific hedge fund strategies. This results in a solid and well-diversified portfolio having superior adjusted risk returns. After all, the hedge funds have proven their supremacy by making huge money in any market environment. Competition While there are a number of hedge-fund replication ETFs on the market that use a fund-of-fund approach, there are only a few that use a stock-selection methodology. The ultra-popular the Global X Guru Index ETF (NYSEARCA: GURU ) uses a proprietary methodology to compile the best ideas from a select pool of hedge funds by looking at the 13F document on a quarterly basis. The ETF has AUM of $266 million and expense ratio of 0.75%. The other popular name in this regard is the AlphaClone Alternative Alpha ETF (NYSEARCA: ALFA ) , which has garnered $161.6 million in its asset base while charging 95 bps in fees per year. It uses a proprietary ranking system, ‘Clone Score’, which ranks hedge funds and institutional investors based on the efficacy of replicating their publicity disclosed positions. The IQ ARB Merger Arbitrage ETF (NYSEARCA: MNA ) is an event-driven hedge fund that might give stiff competition to DRVN. This fund offers capital appreciation by investing in global companies for which there has been a public announcement of a takeover by an acquirer yet provides short exposure to global equities as a partial equity market hedge. The product has amassed $130 million in its asset base and charges 75 bps in annual fees. Given that all these products have been able to build up decent assets, it might not be difficult for the Highland products to see solid inflows and garner investor interest given that the interest rate hike might lead to uncertainty and bouts of volatility. Link to the original post on Zacks.com

GURU And ALFA: Are Hedge Fund ETFs Worth Your While?

Summary There has been a great deal of interest in ‘hedge fund cloning’ ETFs of late. Despite exhibiting decent performance, a closer look reveals a different story. We remain skeptical of their alpha potential, after a detailed analysis of their track record. There has been significant interest in recent years in “cloning” the equity investment ideas of hedge funds, leading to the launch of several ETFs and indices that track their stock picks. In this article we provide an assessment of the two longest running ETFs, the Global X Guru Index ETF (NYSEARCA: GURU ) and the AlphaClone Alternative Alpha ETF (NYSEARCA: ALFA ). GURU and ALFA At a Glance Despite both being “copy-cat” funds, GURU and ALFA are actually two quite different propositions. Key Features From an investment strategy perspective, the GURU is designed to be 100% long, while the ALFA has the flexibility to go short by 50% subject to market technicals. In other words, one is a long-only equity fund, while the other aims to mimic long/short equity hedge funds by altering its market exposure over time. Due to its hedging ability, the ALFA appears to charge more for this feature, with the expense ratio close to 1%. Portfolio Characteristics A key difference between the two ETFs is their stock weighting methodology. GURU weights its positions equally, and has fewer positions in total. The ALFA applies variable weighting, with higher weights assigned to higher conviction names based on a proprietary scoring methodology. It is more concentrated than GURU in the top holdings, but has a long tail of smaller positions. It is difficult to say which method is more effective, only time will tell. Both portfolios comprise mainly of U.S. stocks, which is intuitive as hedge funds do not disclose their overseas holdings in 13F filings – unless they are U.S.-listed securities, such as ADRs. In terms of portfolio churn, both ETF portfolios have fairly high turnover ratios. For GURU, this is at a staggering 128%. We believe a high turnover is only justified if it results in superior performance, otherwise it typically cranks up excessive trading costs and impacts long-term returns. Portfolio Composition According to Morningstar classifications, both ETFs have a pronounced mid/small-cap bias, as evidenced by their high allocation to SMID cap stocks. The ALFA has a more aggressive tilt than the GURU. From a sector perspective, we would note the high allocation to the tech sector of both funds, although it is not too far from market index weights, as defined by the Russell 1000 Index. Performance Benchmark As both ETFs are essentially U.S. equity funds and exhibit a mid-cap orientation, we believe the Russell 1000 Index (“R1000”) is an appropriate performance yardstick. The Vanguard Russell 1000 ETF (NASDAQ: VONE ) tracks this benchmark and charges a 0.12% fee. Quantitative Analysis – Last 31 Months (1 Jul 2012 – 31 Jan 2015) Below is a summary table of key MPT statistics for the past 31 months, based on monthly data. Investment Results Both the GURU and ALFA have done well over the past 31 months (since common inception date), posting modest outperformance versus the Russell 1000 Index. Risk Both ETFs have exhibited higher volatility than the R1000 (as measured by the standard deviation). At ~11%, this is some 30% higher than the market index. From a beta perspective (sensitivity to equity market movements), both are also higher, at 1.20 and 1.08 respectively. Alpha Alpha is a measure of manager skill on a risk-adjusted basis, in other words it reconciles return and volatility to provide an indication of stocking picking skill. After accounting for volatility, the GURU’s alpha is negative, and the ALFA’s is mildly positive. GURU’s outperformance over the R1000 appears to have been achieved with higher risk. At 1.2 beta, it is akin to R1000 running on steroids, but less efficient. To illustrate this point, if we levered the R1000 to a similar level (beta of 1.2x), this would have yielded better returns at lower volatility. Tracking Error GURU and ALFA are both high tracking error products, meaning their performance pattern can diverge significantly from the R1000 from time to time (both positive and negative) — and benchmark-aware investors should be prepared to stomach this performance divergence. Risk Adjusted Returns Both ETFs have posted identical and good risk-adjusted returns in terms of Sharpe Ratio. However, the slightly levered R1000 once again leaves both ETFs in the dust. Taking It All Together Despite outperforming the R1000 Index in the past 31 months, the alpha of these ETFs are not significant (and negative for GURU), after taking into account their volatility. A Longer Term Perspective For better understanding of the performance pattern of these ETFs, we can look at the indices that they track, which has been back-tested over longer periods. However, one must note that these are “back-tests” and must be treated with a degree of caution. After all, a back-tested index must demonstrate favorable results before a ETF provider is willing to wrap it into an investment product. We do not know how conservative the index producers have been with their assumptions, so we will look no further back than the past 60 months (or five years). 60 Month Statistics (1 Feb 2010 – 31 Jan 2015) The longer term stats paint a similar picture. Guru Index Alpha is again negative over the past five years. Its higher return is explained by higher beta. A similar version (1.1x) of the R1000 would have achieved higher returns at lower levels of volatility. AlphaClone Index Alpha is high at 4.6. This number is a result of a) lower volatility than the R1000 and b) similar level of return. Its 60-month beta is 0.66, a third of the market index. This implies that its market hedge mechanism must have kicked in during this 60 month period, which has provided some protection in down months of the R1000. Despite the existence of alpha, we would note the following: In the period since the ALFA ETF has been live, hedging has not been used, as indicated by its beta of 1.1 to the R1000. It would be interesting to see how it works in practice in the future. In absolute return terms, the back-tested performance of ALFA over the past 60 months is still inferior to the R1000 (15.2 vs. 15.8). A skillful equity long/short hedge fund manager would typically be able to capture less downside, but a similar level of upside, resulting in better returns than the market index over time. This indicates that AlphaClone’s market hedge (think of it as the manager’s skill in shorting the market) have not helped drive extra returns over this 60 month period. A Closer Look at Alpha Patterns We believe outperformance from stock selection comes in waves, and is not constant. There will be extended periods when a portfolio performs well, and extended periods less well due to the existence of style biases (i.e. growth, value, size effect etc). These biases can be in, or out of favor with the market from time to time. To assess alpha patterns we look at the rolling 2-year excess returns versus the R1000. Our assessment period is the last 60 months, as above. Interestingly, the Guru Index has been losing altitude of late, with its margin of outperformance vs. the R1000 dropping fast. This points to a deterioration in its stock selection — possibly due to style biases, a decline in the performance of hedge funds they track, the efficacy of their cloning process, or a combination. Meanwhile, the AlphaClone Index has lagged the R1000 for years (on a rolling 2 year basis), before taking a positive turn in late 2013. This is most likely because the index has very much been long-only and not market hedged since then. Tracking Quality One final factor to consider is the quality of index replication. The good news is that both ETFs appeared to have tracked their underlying indices well after fees in real life. The tracking error is marginally higher for the GURU in the past two calendar years, despite having a lower fee than the ALFA. Our Verdict Over the past 31 months, the GURU and ALFA ETFs have performed well in absolute terms, although if one takes a closer look, reveals a different story. For GURU, we are concerned of its high beta, high portfolio turnover, and stock selection efficacy which has been decreasing recently. For ALFA, we are not big fans of its higher fees and market hedge, which has not been tested in real life. As long-term equity investors interested in maximum capital appreciation, we do not believe that market timing adds value. This is confirmed by the ALFA’s subpar returns to the R1000 over the period under review. Based on our analysis, we remain skeptical of both ETFs’ alpha potential. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: For research purposes, Real Return Partners LLP compile the RR Partners AlphaEquity® Index (Bloomberg: RRALPHA). This is a long-only equity index that tracks the performance of a portfolio of 20 US-listed, 13F equity positions representing the best ideas of an elite group of institutional money managers. The Index is independently calculated and is published as a net total return index. There are no investment products linked to this index.