Hedge Fund Replication Worked in January. Here’s Why.

Managers of hedge fund replication strategies—the alternatives version of index funds—use quantitative models that track multiple managers’ changing factor exposures, whether they are betting on technology stocks, emerging markets, or small cap stocks. The idea is to deliver hedge fund return streams to investors at a lower cost and without the risks of betting on a single hedge fund manager.

The market volatility in January was allegedly theresult of amateur investors hoping to take down prominent hedge fundsby driving up the prices of stocks like GameStop and AMC that the managers had been shorting, or betting on a price decline. These investors, chatting for months on Reddit’s WallStreetBets forum, bought options that sent the stocks soaring, catching hedge funds in a so-called short squeeze. Some hedge funds were left scrambling to buy stocks at rising prices to cover their risky bets.

But here’s how one strategy designed to replicate the performance of equity long-short funds did: Dynamic Beta Investments’ exchange-traded fund (DBEH) was up two percent in January. The HFRI Equity Hedge index, which represents these funds, was up an estimated .8 percent in January. The MSCI World was down 1 percent.

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Dynamic Beta’s ETF models the exposures of more than 20 funds, reducing the risk of bad bets from any one manager. (In January, for example, Citadel and Point72 Asset Management invested $2.75 billion in Melvin Capital after huge losses from Melvin's GameStop short.)

Andrew Beer, managing member of Dynamic Beta, explained in an interview why Dynamic Beta’s ETF beat actual long-short hedge fund managers last month, despite the volatility. For one, actual equity long-short funds, the category hit the most by the frenetic trading, made profitable bets that more than covered some of the losses on short positions.

“The key driver is the factor rotation among equity long-short hedge funds that began last summer,” he said. “The GameStop phenomenon was a tempest in a teapot: very damaging for a few funds, but insignificant across the industry.”

Beer estimated that the ETF's January outperformance stemmed from being able to deliver 3 percent in alpha relative to the MSCI World index that managers earned on bets on undervalued emerging markets and small cap stocks. As a result, while the MSCI World was down 1 percent, the ETF was up 2 percent.

Actual hedge funds, however, lost another 1 percent on single stock short positions. The ETF, in contrast, only invests in index futures contracts, not single stocks. The ETF benefited from actual managers’ emerging markets and small cap positions, without getting hurt by the shorts.

Unlike many of the GameStop investors, Beer wants hedge fund managers to do well. Replication has benefitted from the strong performance put up by equity long-short managers recently.

“We need hedge funds to be smart,” said Beer. Equity long-short hedge funds put up lousy numbers between 2010 and 2019. “We have had the world’s greatest pyrrhic victory in that during the 2010s, we consistently outperformed mediocrity. But the better hedge funds do, the better we do.”