Imagine hedge funds without brainy managers maneuvering artfully through short-lived market opportunities day in and day out.
You might think the flashy hedge-fund arena could never evolve into this. But with about $1.2 trillion in assets, the industry is maturing. And as it does, analysts are looking for ways to capture the advantages of hedge funds without the tremendous fees and egos that go with the territory.
Attention is turning to what is known as passive investing. That's the term that applies to index mutual funds, and that means setting up a portfolio and keeping it intact without human tinkering day to day.
What's envisioned for hedge funds tends to be somewhat different than mutual funds. The focus isn't on replicating an index like the Standard & Poor's 500, but can be on identifying the special elements that power various types of hedge funds and then building those mechanically into a portfolio.
Academic studies suggest this can be done, and potentially at a low cost, said Ryan Tagal, director of hedge-fund research for Morningstar Inc.
Wall Street is increasingly intrigued with the possibilities.
"As the hedge-fund industry matures, and it becomes increasingly difficult for many investors to identify and invest in the top-performing hedge funds, passive management should gain wider appeal with hedge-fund investors," Merrill Lynch derivatives analyst Benjamin Bowler said in a recent report.
He notes that with the sharp growth of hedge funds, it is becoming tougher for active managers to excel. In that environment, he said, it's also more difficult for "investors to justify paying hedge fund fees for the performance of the average active manager."
So passive alternatives represent a natural evolution in an increasingly mature industry.
The typical hedge fund charges 2 percent of assets and 20 percent of profits, fees that pension funds and wealthy individuals are willing to pay for the best and the brightest who truly enhance returns with unique strategies. But with so many new hedge funds competing, it's becoming increasingly difficult to employ strategies that others aren't exploiting.
Bowler notes that when the mutual fund business became crowded, and many failed to outperform the S&P 500, the environment gave birth to index funds. Because index funds don't pay for expensive talent and other costs involved in active management, they tend to perform better than active managers.
The Vanguard Total Stock Market Index fund, for example, charges 0.19 percent, while the average mutual fund charges 1.4 percent. With the low costs, the fund has beat 75 percent of active large-cap funds over the last 10 years and averaged an 8.56 percent annual return.
Since 1990, passively managed mutual funds have grown from 2 percent of stock mutual fund assets to about 17 percent.
Many pension funds use index funds for about 40 percent of their stock market exposure. Then they try to enhance returns with talented active managers. Increasingly, that's meant using hedge funds.
Bowler said the passive approaches could include tracking hedge fund benchmarks by mechanically investing in all hedge funds using an investable benchmark, perhaps a device similar to an exchange-traded fund or a mutual fund that simply mimics the full array of hedge funds. Passive investing also could involve investments in liquid assets that statistically track hedge fund returns, or the funds could mechanically invest in the basic strategies similar to those hedge funds execute.
The academic research has shown that many hedge fund investment styles can be replicated by using long and short strategies with assets that trade on an exchange.
Massachusetts Institute of Technology professor Andrew Lo, along with graduate student Jasmina Hasanhodzic, for example, replicated the performance of 1,610 hedge funds between 1986 and 2005 using investable assets that included the U.S. dollar index, the Lehman corporate AA bond index, the spread between the Lehman BAA index and Treasuries, the Standard & Poor's 500 and the Goldman Sachs commodity index.
According to their paper, "Can Hedge Fund Returns Be Replicated? The Linear Case," the so-called hedge fund clones achieved higher risk-adjusted returns than certain types of hedge funds. But some strategies, such as convertible arbitrage, were not possible because investment products didn't apply. The passive clones provided an annualized return of 12.8 percent compared with 14.2 percent for the full array of hedge funds over 18 years.
Currently, passive strategies remain "a concept that is being talked about," Tagal said. But he said he believes individual investors may find them available in the retail market within three to five years.
Contact Gail MarksJarvis at firstname.lastname@example.org or leave a message at 312-222-4264.Copyright © 2015, Los Angeles Times