By periodically investing in an index fund, the know nothing investors can actually outperform most investment professionalsWarren Buffett
Most mutual funds underperform their benchmarks and this statement is common knowledge nowadays. According to different research sources the percentage of the funds losing the market battle is somewhere between 80 and 90 percent. This only proves how challenging it is to extract the top 10-20 percent of the best performing asset managers. Only those investors who have outstanding fund research and due diligence process in place have a chance to find the true diamonds.
Having taken into account the above statistics, it makes sense to have in your portfolio considerable exposure to index tracking funds. That way you can increase your chances to stay in line with your reference benchmark. This approach makes a lot of sense as index tracking funds leave you with peace in mind that you won’t be at least lagging the market. On top of that they come at a lower cost, as ETF’s charge a lot less that mutual funds.
As passive investments became very popular over the past years, investors started looking at the new ways how they could allocate their money. Staying in line with the benchmark was simply not enough. Investors were demanding a lot more: they wanted to gain exposure to the magic alpha, the Holy Grail of investing that would consistently beat the reference benchmark to deliver the extra value on top of the passive approach.
Back in 2012 two ETFs were launched that replicate hedge fund like strategies. Hence it has been more than 9 years now it is possible to make some conclusions with regards of the performance track records. The two ETFs are the AlphaClone Alternative Alpha ETF (ALFA) and the Global X Guru Index ETF (GURU) both listed on the US exchanges.
The AlphaClone Alternative Alpha ETF seeks to track the price and yield of the AlphaClone Hedge Fund Masters Index. Prior to December 27, 2017, the Fund’s investment objective was to track the price and total return performance of the AlphaClone Hedge Fund Downside Hedged Index.
The AlphaClone Hedge Fund Masters Index tracks the performance of US-traded equity securities to which hedge funds and institutional investors have disclosed significant exposure. The proprietary index methodology developed by AlphaClone ranks hedge funds and institutional investors based on the efficacy of replicating their publicly disclosed positions. Equities are selected from those managers with the highest ranking. The ETF charges 65 bps.
On the other hand, the GURU ETF allows investors to access the high conviction investments of some of the largest, most sophisticated hedge funds in the world. By investing alongside hedge funds, GURU seeks to benefit from their top tier research and knowledge to outperform US equity benchmarks such as the S&P 500 and comes with an expense ratio of 75 bps.
Indeed, both ALFA and GURU ETFs offer a unique opportunity for investors to access the investment ideas utilized by the hedge fund industry as a result of the underlying indices they follow. However, there are certain market conditions when the ETF’s heavily underperform the S&P 500 Index and as a result of this fact underperform the US market benchmark in a long run.
It seems long-term investors should stick with the passive SPY ETF that tracks the S&P 500 Index and charges only 9 bps which is only 14% of the ALFA’s and 12% of the GURU’s expense ratio.
So let’s dive into the details.
Here is the chart with the reference benchmark SPY ETF with performance charts for the SPY, ALFA and GURU ETFs respectively. Since April 30th, 2012 both ALFA and GURU underperformed the SPY. The SPY returned 299.93% over the specified period of time while the ALFA delivered 268.06% and GURU only 255.48%. In order to make the numbers very clear if you invested $1,000,000 at the very beginning in each of the ETF’s separately, the ALFA would have made $318,700 less than the SPY and the GURU would have made $444,500 less than the SPY. Very disappointing, having taken into account the big difference in fees.
What are the main factors that long-term contributed to the underperformance of the ALFA and GURU in relation to the SPY ETF?
In order to answer to the above question, let’s have a look at the following ratios:
the ALFA vs. SPY ratio (ALFA:SPY)
the GURU vs. SPY ratio (GURU:SPY)
During the second half of 2016 the SPY went trendless and it seems the ALFA and GURU strategies did not manage to navigate well in the market with no clear direction. Both strategies underperformed on the relative basis. Just see blow a bit closer what was happening with the performance at that time.
The impact of the both ETF’s underperformance in 2016 on the overall relative performance to the SPY track record until today is very substantial. On top of that if you add the impact of the cumulative expense ratio over the long period of time you are on the best way to underperform.
The above analysis proves how important is the due diligence of the underlying positions. The GURU ETF provider claims the expense ratio of 75 bps is efficient as traditionally, investing with a hedge fund requires paying an ongoing 2% management fee and 20% of profits. To be honest this statement is not fully true as most of the hedge funds nowadays charge closer to the 1.5/15 or 1/15 fee structure. The 2/20 fee structure can be applied only by the best of the best hedge fund managers. That’s the harsh reality.
The investment ideas on its own without a proper investment strategy that works can be useless. It seems the investors were smart enough to notice the performance and cost related issues and decided not to reward the hedge fund like ETFs with their allocations. Both ALFA and GURU have only $109 million in assets in total having the trading history of more than 9 years now. That’s not the best investment story, however it should serve as a warning there is no easy way to construct a successful index. The catchy Alfa and Guru names did not make the trick this time. Moreover, not sure what is going to be the future of those ETFs but probably not the brightest unless the indices get revised and the charges lowered towards the more realistic market limits.
Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. Algo-Chain did not own any shares of the mentioned ETFs at the moment of writing this article.