By Tim Edwards, Senior Director, Index Investment Strategy, S&P Dow Jones Indices.

Tim Edwards, Senior Director, Index Investment Strategy, S&P Dow Jones Indices.

With the final numbers for the second quarter of 2015 now available, the research firm ETFGI brought some long-anticipated news: the size of the exchange-traded funds market has finally exceeded that of its older, more well-to-do cousins.  It may have taken a little longer than we expected, but ETFs are now a bigger part of the market than hedge funds.

In order to explain why hedge funds might be losing out in the race for assets, we thought we would re-examine the challenge of replicating hedge fund performance.  When it comes to individual hedge funds, which are typically unconstrained by assets, leverage or geography, replication is a difficult objective.  When it comes to a broad hedge fund portfolio, replicating performance is easier than you might think.

To begin the replication process, our “hedge fund” is going to invest half its money in U.S. bonds, and the remainder in global equities.  (We’ll use the S&P U.S. Aggregate Bond Index to represent the first portion and the S&P Global 1200 for the second.)  Assuming we also rebalanced on a monthly basis, here’s how our hedge fund would have performed over the past five years.  For purposes of comparison, we also show research firm HFR’s benchmark of hedge fund performance.  The HFR Fund-Weighted Composite Index includes funds which are no longer open to new investors, so it is a fair representation of what only the largest and best-connected asset owners may have available to choose from:

Sources: S&P Dow Jones Indices, HFR as of 30th June, 2015.

The pattern of returns seems similar, which is encouraging.  And our decision to allocate to equities and bonds in equal proportions means that the overall return from our replication strategy is much higher.  Well done us!

But congratulations are premature.  Our replication strategy does not include costs, or fees.  The replication costs of broad-based, passive indices are de minimis, but we should not undervalue our unique insights (we are replicating a hedge fund, after all).  A fee of 1.50% per annum seems reasonable, and we’ll take 15% of any profits (provided we’re at least breaking even over the past 12 months). Here’s how our performance looks now:

Sources: S&P Dow Jones Indices, HFR as of 30th June, 2015.

That’s more like it; our replication strategy now performs very similarly to the average hedge fund.  And when it comes to the pattern of returns, are we replicating the hair-trigger market-timing and monthly swings of the masters of the universe? Yes, we are:

Sources: S&P Dow Jones Indices, HFR as of 30th June, 2015.

One conclusion to draw is that perhaps there is a market for a product offering a 50/50 split of U.S. bonds and global large-cap equities, at a highly remunerative cost structure.  The other conclusion, perhaps shared by those whose continued flight to low-cost index funds are making the headlines today, is that the average hedge fund looks like a fixed blend of cheap.