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Hedge funds have employed a variety of strategies over the past several decades, some of which have succeeded spectacularly. But this asset class has historically had high fees, and has been inaccessible to all but the largest investors.
Andrew Beer, co-founder at Dynamic Beta investments (DBi), joins the show to discuss how the “index revolution” has finally come to the hedge fund industry, and how individual investors can participate.
Watch On YouTube
- Background Andrew’s career, and the events that led to the creation of DBi.
- A short history of hedge funds, including when they’ve performed well, and when they have largely fallen short.
- Details on factor-based hedge fund replication, and how it has laid the groundwork for an “index revolution” in the hedge fund asset class.
- Why certain types of hedge fund strategies can’t be easily tracked with a replication strategy.
- How long/short equity strategies work in the real world.
- An inside look at DBEH, the iMGP DBi Hedge Strategy ETF.
Featured On This Episode
- DBEH – iMGP DBi Hedge Strategy ETF (iMGP Funds)
- DBMF – iMGP DBi Managed Futures Strategy ETF (iMGP Funds)
- The Index Revolution Finally Comes To Hedge Funds (DBi)
Today’s Guest: Andrew Beer, Dynamic Beta investments (DPi)
- DBi (Dynamic Beta investments) – Official Website
- DBi on LinkedIn
- Andrew Beer on LinkedIn
- Andrew Beer on Twitter
About The Alternative Investment Podcast
The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.
Andy: Welcome to the “Alternative Investment Podcast.” I’m your host, Andy Hagans. We’re continuing our series on liquid alts and alternative ETFs. And today, we’re talking about hedge funds and some intriguing new ETFs that compete with them. And joining me is Andrew Beer, who’s co-founder of Dynamic Beta Investments, aka, DBI. Andrew, welcome to the show.
Andrew: Andy, thank you so much for having me. It’s a pleasure to be here today. Happy New Year, by the way. Yeah.
Andy: Oh, yeah, Happy New Year.
Andrew: Happy New Year, everyone.
Andy: I think this will be airing maybe late January, but we’re recording on the 5th…
Andy: …in case the markets like plummet and then recover in between or something. But I wanna dive into the liquid alts market and some of these unique strategies in your ETFs. But first, could you give us a brief introduction to your company, your career, and how long you’ve been around?
Andrew: Sure. So, I’ve been around for a long time. I actually started in the hedge fund industry in 1994, doing very traditional hedge fund things. And then, in the early 2000s, I was known for having started hedge funds, one in the commodity space, and another one in the Greater China region. And everything I always did, I did with partners. But, you know, my obsession over the past 15 years is now what has become the liquid alts world, which is, if you want the diversification benefits of a given hedge fund strategy, but you can only access it through a mutual fund or an ETF or some other lower cost daily liquid regulated vehicle, how do you actually do that? And, well, I guess, can you do that and how do you actually do that?
So, our business is focused on one very specific way of doing that, in that, we do something called hedge fund replication. And the idea of hedge fund replication is that in certain hedge fund strategies, a handful of big trades drives all their performance. And if you can figure out what the big trades are today, then if you can copy them and do it efficiently, you tend to do as well or better than the actual hedge funds. But because you’re not investing in hedge funds, which have high minimums, illiquidity, etc., you can then also package it in a mutual funder an ETF. And in the U.S., we’ve set up and run two ETFs that are really designed to bring two specific hedge fund strategies, equity long-short, and then manage futures to the broader ETF world, which, as I think you probably know from your experience, it’s had a very, very, very hard time building hedge fund strategies in an ETF vehicle that are anything other than terrible. And so, we’re trying to really change that perception, and really get down to the principles as to what it is that people are looking for and how to get there.
Andy: Yeah. And I guess a little personal question because I can hear the passion in your voice just talking about this. With DBI, are you more an entrepreneur who saw this segment that was ripe for, you know, market disruption? Or, are you more of like an academic nerd who’s like just, “I wanna solve this riddle,” you know, “This keeps me up at night.”
Andrew: I am absolutely both. So, I almost went into academia when I was at Harvard Business School, I basically had three job choices. I could have gone into academia. I was recruited to go into the doctoral program. Also, I really thought I was actually gonna be a private equity guy. It’s kind of where my… I like to kind of slow deliberate, you know, information-based approach of private equity. And then I had this chance meeting, in an interview, with a hedge fund and I just thought it was really cool what they were doing. It was very off the run, and, you know, kind of appealed to, I would say, the nerdy side. People have called me a disruptor in the space. I didn’t intend to be, all right?
It was basically in 2006, 2007, one of the big… This issue of, can I get hedge fund performance? But with liquidity was a huge issue across the space because you had fund of funds and institutional investors who desperately wanted more client-friendly ways of getting exposure to the space. And when I heard about this quantitative approach, and I’m not a quant, but you know, I often joke that if I can’t write it out on a napkin, it’s not something I would do, but this idea of basically using established risk models to figure out what big hedge funds are doing, it made sense, not just to me, but I would go talk to actual hedge fund managers. I talked to the guys at Baupost where I started my career and said, “Hey, if I could figure out with pretty good precision what major markets you’re in, do you think I would do similar to you?” And every hedge fund I spoke to said, “Of course,” right? It’s always about the big trades.
We love to talk about the, you know, 1% position that we just put on last week, but that doesn’t move the P&L needle. We’ve gotta have big exposure to EM, or short value, or long growth, or vice versa. And so, what happened was, I got the door slammed in my face 100 times out of 100 times. And I don’t know, there’s a just sort of a doggedness to it. It’s been such a strange 15 years in that, we’ve done better than anyone possibly could have expected, right? When people are… Our strategic investor bought a stake in us in 2018, they’d spend two years looking at the [inaudible 00:05:35] world. They said, “We’d never found anybody who’s done better than hedge funds with lower drawdowns, low fees, and daily liquidity. But, you know, why aren’t you guys huge?”
And then I described all the issues that a lot of people who were just not interested in what we were doing because it was boring, right? It was index-like. And so, when they took a stake in us, it was basically, let’s try to find the right audience for your products. And so, in a sense, with this whole business… And you know, we have managed a bit over $2 billion now, and we grew three times last year. But, you know, my friends constantly mocked me about this 15-year overnight success story because they saw me for years and years and years. You know, every year I would say, “I’d bet institutional consultants would like it.” And then they would slam the door in my face. Or I’d bet these guys would like it and they would slam the door in my face. And so, I think in the ETF world, we finally found it. And how we ended up getting to it, you know, it was sort of a long drawn-out process. But we’re very excited about the opportunity set today.
Andy: Yeah. And nothing teaches you like getting doors slammed on your face, right? And on that note, actually, so on the “Alternative Investment Podcast”, historically to date, we’ve mostly covered illiquid alternative investments. And we haven’t covered the liquid side as much. But increasingly, you know, liquid alts, illiquid alts, some of these lines are being blurred and these products are competitive. And where I’d like to start, I’d like to actually zoom out for a second and talk about traditional hedge funds, right, because it’s important. It’s important to understand traditional hedge funds, what they do well, as well as, you know, what are their drawbacks, right? So obviously, your product is competing or it exists because there are drawbacks to hedge funds, but they also must have some utility and some value for investors or high net worth investors, family offices, institutionals wouldn’t be, you know, giving them capital year in and year out for decades now, right? So, what do hedge funds do well and what do they not do well?
Andrew: So, when you say hedge funds, first of all, the thing you have to understand is there are a million different kinds of hedge funds. And within each of those categories… Or there are lots of different categories of hedge funds, and with each individual category, it’s like saying equities and then, you know, you can kind of break that down into categories and industries, etc. So some of the truisms about the hedge fund industry are that most strategies wax and wane over time. Like, so managed futures was the hit strategy last year. You know, equity long-short and discretionary macro were basically on their back heels going into 2020. And then both had suddenly good years. The other truism is that with the exception of possibly a handful of people, literally, nobody knows who’s gonna do well next year, right? So, you’ve got the hedge fund industry here, and then a whole allocation infrastructure built on top of it that is expensive, and the hedge funds themselves are expensive. And the whole infrastructure is built on the fiction that we won’t invest in the average fund. And so…
Andy: And by the way, is 2 in 20 still the standard, or has there been any…
Andrew: Well, there’s been a huge bifurcation. I mean, some funds can’t raise money no matter how much they drop their price. But the largest funds are raising fees. And they’re telling investors, if you wanna stay invested with us, you can’t get out for five years. And then, even then, you can get out a little bit each quarter. So, you know, I have sort of a complicated relationship with this because I think people wildly overpay for certain hedge fund strategies a lot. But I also think that other hedge funds, I’m sort of known as somebody who’s written a lot about this. My first editorial in the Financial Times was talking about how 80% of hedge fund Alpha was paid away in fees. On the other hand, I’m also a guy who thinks that certain hedge funds are worth every penny. You know, these multi-strategy hedge funds that are like elephants dancing on, you know, the bow of a ship in a hurricane and balancing a martini on their fingers. Like, their agility in these markets has been incredible. While everything else has been going up and down, they’ve just coasted right through it and put up tremendous returns.
But I think, you know, hedge funds overall, you’ve got tremendously smart people. Right? You have opportunities that come up that they will capitalize on that the average investor cannot capitalize on. The inflation trade, right? I was talking to people about the inflation trade back in early 2021 because a hedge fund legend named Stan Druckenmiller, basically raised his hand and said, you know, “Everybody thinks that inflation is never gonna be coming back. We’re gonna have low rates forever. And I think that’s probably wrong.” And when I heard him say that, I used to kind of joke that taking the other… So, this is the guy who was Soros’s as right-hand man when they bet against the pound in the 1990s. And he’s probably the greatest macro investor of the past 40 years. I was like, you know, taking the other side of the trade from Stan Druckenmiller, is generally investment suicide. You know, it’s like you wouldn’t… Warren Buffet buys a stock, you wouldn’t say, you know, it’s a terrible idea in general. But I went on and talked to people, and what I realized was that people really didn’t have things… A typical advisor didn’t have things in their toolkit to deal with this change in the world. You know, were they really gonna go out and start shorting treasuries? Were they gonna start making a big bet on certain segments of the commodity markets? Were they going to make big currency plates? You know, were they gonna…
Andy: And what are you gonna take a 60/40 portfolio and remove all the bonds? You know, for…
Andrew: Well, right. So, people were locked in. Right. So, most of the investment world is locked into their positions in some way. And they’ll move a little bit, but they can’t move very much.
Andrew: You know, one of the things I’ve learned in 30 years of doing this is, you can take an incredibly smart guy and layer all sorts of constraints on him, and in general, he’s not gonna do that much better than the guy who you think he’s a lot smarter than, you know, constraints. And so, the hedge funds in the early days had no constraints. You wake up on Jan 1 in the morning, and you could be doing something completely different that year than what you were doing the prior year. As the business has become institutionalized, it’s become much harder for them to change. And I was just quoted a couple of times talking about some of these, you know, hedge funds with big tech exposure.
Well, you know, now there are tech-focused hedge funds. And 20 years ago, somebody might have been a tech-focused hedge fund one year, then an emerging market specialist two years later. They don’t really pivot and change the way that they do. But overall, okay, you’ve got tremendously smart people who have a lot more flexibility overall than a typical advisor or family office who they move in very, very small increments and very slowly. And the fact that 95% of the world’s capital has those constraints and these guys don’t, just gives them an enormous advantage over time. So, you know, I’ve written actually quite favorably about hedge funds in the 2020s versus the 2010s. Because I think we’re gonna look back on the 2010s and just think it was the weirdest period of financial history we’ve ever seen. I mean, all these things that just weren’t supposed to happen just happened, and then they got worse.
Andy: It sounds, to me, like there’s almost a disconnect between, I wanna say, the marketing angle of, I become known for this specific product segment or sector or sub-sector or this specific strategy, so that’s what I have to sell as a hedge fund manager because I’m known for this and I know I can raise capital for this specific thing, but then that’s a constraint and it’s probably not going to outperform for three market cycles in a row. Or like part of the point is the flexibility, right? But we’re tasked to sell product, it has to be a blue widget and I’m buying a blue widget and I want it to be blue, I’m expecting it to be blue.
Andrew: And you’re looking at a guy who made money with $500 million in assets under management and because he is done well, he’s managing $32 billion today, right? I mean, when I started at this firm, Baupost, it’s $600 million in AUMs, and then 15 years later, it was $32 billion, right? So, it just changes what you do. You know, I think the hedge fund industry, you know, in a sense, it became an asset class. And during the 2010s, there were some… The people who control the capital that goes into hedge funds have always had a lot of influence on the industry. And in the 2000s, it was a lot of fund of funds were siphoning capital into the industry. And then in the 2010s, it was institutional consulting firms.
And my impression was that institutional consulting firms took the wrong lesson away from 2008, in that, they looked at 2008 and they saw hedge funds… First of all, 2008 was a huge disappointment in the hedge fund industry. You have to remember that in the beginning of 2008, hedge funds looked like they could do no wrong, right? They’d gone into the dot-com crisis with actually about a 30% exposure to the equity markets. The equity markets go down 50% over the next few years and they’re up. Like, how do you actually do that? Well, they were very long small-cap value stocks and very short large-cap growth stocks. And they held those positions for a long period of time. So, it’s not that their stock picks didn’t go down, they went down 40, not 50, but a lot of their shorts went down 80%. Then by the time the subprime crisis rolled around, you know, again, there were a lot of hedge funds who were shorting subprime in 2004, 2005. They didn’t make it to 2007. But the ones who made it, you know, they thought, boy, if the real estate market rolls over, the subprime instrument that I’m shorting might go from 100 to 80. And instead, they went from 100 to 20. Right?
And so, you’re coming off this period of these huge windfall profits. And if you ran an asset allocation model at the end of 2007, it shed, forget everything else. Put 80% in hedge funds, and 20% in cash. Then 2008 rolls around. And if you’d asked 100 allocators to hedge fund at the end of 2007, you know, and said, we’re gonna have a big bear market next year and the world’s gonna implode. And you know, how much you think hedge funds would go down, everyone would have said flat, maybe up a little bit. They’re hedged, right? They’re supposed to. Those are the markets they live for. And equity markets went down 40, and they went down more than 20. Plus, you had Madoff, right, which… Now, Madoff wasn’t just about Madoff, but Madoff was also about this collusion between hedge funds and accountants who were allowing them to pretty much mark anything wherever they wanted. So, it’s sort of it’s a predecessor to a lot of the noise you’re hearing now about private assets and valuations and things. But what Madoff did is it kind of underscored that accountants would have risk if they just blindly signed off on things. So, you had this kind of unwinding of a lot of strategies that had never really had to mark out assets. So, all of a sudden, everything was happening sort of the end of 2008.
And then the third thing you had was a lot of the allocators who, like fund of funds, that were allocating to the space had promised their investors monthly liquidity. And that’s back in 2007. That’s the issue I was trying to solve for them. It’s like, give us some of your money so you can actually be redemptions if they ever come. But for a lot of reasons, they decided that if they did it with us, that we would cannibalize the rest of their business. So, those three things happened. And what institutional consultants kind of took from that, and a lot of family offices took from that is, we want our hedge fund portfolio to have zero beta, zero structural beta, and we’re gonna give all of our money to guys who didn’t go down in 2008. And so, what you ended up with a lot of very, very structurally market-neutral funds that were supposed to do cash, plus a few hundred basis points over time. So, the problem was cash was zero for the next decade.
Andrew: So, what they were doing is they’re taking these institutional portfolios and saying, it’s okay to pay the guy 300 basis points a year because he had a great 2008. But then, the guy does 2 over the next 5 years after 300 basis points. And people suddenly start to question the whole hedge fund industry. Family offices realize that, you know, if you’re doing 3%, 4%, or 5% in a zero interest rate environment, and you’re paying a lot of taxes on it, sometimes it’s not even worth to be in the space.
Andy: Go buy a T-bill, right?
Andrew: Go buy T-bills or Munis, was always the comparison. I’m earning more on my local Munis when I go on a tax-effective basis.
Andrew: So, by the end of the 2010s, hedge funds were really on their back. And you could say very credibly that the diversification argument for the whole space was essentially broken. But you also had another factor, which was, you could not have a worse comparison period versus a traditional portfolio than the 2010s. Right. 60/40 worked, right? Somebody who threw their money into the S&P and just didn’t pay attention for the next 10 years, did better than almost any hedge fund out there. Somebody went into a 60/40 portfolio and didn’t look at it for 10 years, looked better than all these professional investors, I mean, 99% of professional investors. So you had a combination of a low-interest rate environment, kind of institutionalization, kind of adding some constraints, plus a horrible comparison to traditional assets. And a lot of people gave up on the space at the moment that it started to recover. So, there’s always this paradox with hedge funds is, try to look at the past and figure out what the state of the world is gonna look like. And yet, it always seems to surprise us. So, we have certain ways of approaching it, but I think humility is probably the underlying principle that you have to kind of know where you can make reasonable bets in the space and not.
Andy: I think that’s a really good underlying principle. And you know, well, that kind of brings me to the main dish here. I wanna bring up this article that you published on your website. I think this was from 2022. And the article was titled, “The Index Revolution Finally Comes to Hedge Funds.” And I’ll make sure to link to this article in our show notes. But I really appreciated how you explain in a really beginner-friendly way, you know, for a dummy like myself, the idea of factor-based hedge fund replication. And for our listeners and viewers, this is a really key idea. I think you’ve walked us through some of the history of hedge funds themselves, but could you walk us through the history and theory of factor-based hedge fund replication?
Andrew: Sure. So, it started in 2006, and kind of the standard bearer was a professor at MIT named, Andrew Lowe, who wrote a paper with a graduate student that basically said, you know, every Wall Street firm uses these risk models. And the risk models think about the world in terms of these things called factors. And factors are not Tesla, but it’s the S&P 500. It’s not a particular corporate bond, it’s, you know, all AA credit paper or something like that. And so, you know, so one of the big finance things since 1992 when Fama and French wrote their paper on value and small-caps versus large-caps was, people increasingly started to look at the world in terms of different factors. So, all that really means is, from our perspective, it means that if you were to look at a whole bunch of hedge funds and you knew every position they owned today, you could group them.
You could say, you know, okay, they own this much in US large-cap stocks, this much in emerging market stocks, this much in US small-cap stocks. So, you could kind of make these big buckets. And what the paper has basically showed is that if you can figure out how much they have in each of those buckets today, it looks an awful lot like how they’re gonna perform over the next month or two. And so an example was, in 2006, I had a meeting with a quant and he was describing this to me. And I was 15 minutes into this, and I’m not a quant by background, thank God I have partners who are, but he was describing… And I was saying, so wait, you’ve got this risk model where you just look at the reported returns of these hedge fund indices over the past couple of years, and the model use of statistics to tell you are they long or short, the S&P and by how much? Are they long or short, 10-year treasuries by how much? And I said, that’s really interesting because having sat with the hedge fund guys, as I mentioned, it’s always about the big trades, right?
You know, if Seth Klarman is not invested in the equity markets, but one of his peers is in 1995, guess who likely had a better year? And so, I asked him, I said, “Look, just because I need to understand these things in really concrete terms, what would it say today?” And he went and ran the analysis and he said, “Wow, this is really strange. It says a 35% long exposure to emerging markets.” And I said, “Then I’m pretty sure it’s right.” Because every hedge fund that I knew, this was 2006, was obsessed with brick companies. They were hopping on planes to go to China to count the number of cranes, you know, that they would see on the way in from the airport. They were buying cement companies. And so, the idea of hedge fund replication is to look at a big pool of hedge funds, not try to figure out what one guy is doing, and try to boil down their exposure, use these models to boil down their exposures today. There are a couple of reasons why… Sorry, to go back to this idea then, the reason people think of it as index-like, it’s because you’re doing it to a lot of different funds. So, you take the 20 largest managed futures hedge funds, 40 large equity long-short hedge funds, and you get a lot of… And so, just like if you were to do it on the stock market, you could do the same thing with a stock market, but you would pick 500 stocks. And lo and behold, you get the S&P 500.
But you don’t need us to get the S&P 500, you can just get the S&P 500. So, what people have always struggled with in the hedge fund land is, you know, I like equity long-short in concept, but I give it all to Tiger Global at the end of 2020, and I’m down 65% since then. That’s really not the experience that I was expecting. Or it’s 2013, and I give it all to a great value investor like David Einhorn, and I’m sitting with them for years and years and years in the long gaudy winter. And so, what institutions have always done is they spread their bets. So, they go into equity long-short, and they invest in a growth guy, a value guy, a sector specialist, an emerging markets guy. But what are they doing? They’re creating their own index. You know, they’re trying to create something that matches the broad exposure to the category.
Andy: You’re losing the purported value of the act of management because you’re no longer saying, I’m going to pick the 99th percentile active manager. If you’re hiring half the managers in the industry…
Andy: … you’re not gonna…
Andrew: And look, if somebody could figure out who was…everyone could figure out who has been the top guy.
Andrew: Right. That’s the easy part. The problem is today’s top guy is very, very rarely tomorrow’s top guy. And in fact, he’s often worse than average, you know, because he was neck-deep in a particular trade that was on a roaring bull market. And so, the reason this resonates with advisors is that the world of advisors is… their whole fund selection process has two elements. The first is, I build an asset allocation model and toggle it to my client’s risk profile. Let’s say it’s 60/40 on average. But today, if you just do 60/40 and you’re competing with Vanguard, and Vanguard’s doing it for free, or Robo-Advisors are doing it for 25 basis points, you know, you say like, well, I wanna do better than that. I wanna include things that are gonna add diversification value.
The way you do that is you look at strategies, right? You don’t say, “I want a 60/40 portfolio plus a 5% position in Tesla, plus a 5% position in Thai Equities,” right? It’s, you think about it in terms of, do I want to add equity long-short? Do I want to add managed futures? Do I want to add private equity? And so, the first is coming up with an asset allocation model, and thinking this mix of assets is gonna get my clients to where I want them to be in 10 or 20 years. And there’s a lot of art and a lot of science that goes into that. But how you populate that model, every single sleeve of that model, every piece of the pie, the only objective is to match or outperform the benchmark, right? I mean, it’s not… Again, this goes back to, you don’t say, I’m gonna put in something that I have that has no correlation. I have no idea how it’s gonna be, whether it’s even gonna be around in five years.
So the problem is… And if it’s U.S. large-cap equities, the easy answer is to say the S&P 500, right? I’m never wrong. Every time I sit down with a client, he’s gonna say, my S&P 500 index fund did 21.29%, and the underlying benchmark did 29.32% because, you know, it didn’t have like three basis points of fees in it.
Andrew: So, part of the growth of the whole index business is that people much, much more…greater parts of the wealth management world have started to think in terms of asset allocation models and the relationship among assets. So, our contention is that… By the way, and if you’re a pension planner, going back to what I was saying, and you decide you wanna be, let’s say, in equity long-short, you’ll have six or seven or eight different hedge funds in that bucket. But if you look at the position report of one of these hedge funds, it can run 15 or 20 pages. I mean, they have so many individual positions coming down. I’ve seen ones over 200 underlying line items of managers. But advisors don’t do that. No advisor’s gonna sit down with a client that has $350,000 with them and say, I’ve taken your $350,000 and I’ve given $1000 to 350 different funds. So, within each of the buckets, you need something from an asset allocation perspective that gives you exposure to the category.
And you need it in something in an ETF or a mutual fund because your clients aren’t gonna invest in that hedge fund. You don’t want to tie up their illiquidity. And so, the key thing about replication is, it goes from the theory of these are their weights to being able to put it into an ETF or mutual fund completely seamlessly. And so, the ETFs that we built are basically designed to be, “I want equity long-short. Oh, I’ll just use this ETF. It replicates 40 hedge funds. It’s in an ETF. And I want managed futures, I’ll just use this ETF.” So to become the index-like default allocation.
Now, one of the most interesting things over the past 10 years, I coined an expression in 2011. I was sitting with a family office and I said, “In hedge funds, fee reduction is the purest form of the alpha.” And this was a hedge fund who had been first-round investors with Bill Ackman, David Einhorn, Jana. I mean, they were really, really early. They always did better than everybody else, because they didn’t pay what everybody else paid, right? They moved early with their money. They were really important prestigious investors. And so, if everybody else made 10, they made 15. It was like that kind of a… And so, that model has been adopted by the biggest institutional investors. And I was on a pension plan panel on hedge funds a year and a half ago, and I was so surprised because one of the guys at the pension plan said, the way that we invest is to try to reduce fees because we believe fee reduction is the purest form of alpha. And so…
Andy: That’s awesome.
Andrew: I was like, that is not who I expected to repeat that. But so the point is that replication often outperforms because when you copy these big factor positions, if you think that the hedge funds make $10, but you’re paying away $5 in fees, and you’re ending up with $5, if we can copy $8 efficiently and do it at a low-cost vehicle, you might get $7, not $5.
Andy: Yeah. So, if I could think in terms of like percentile performance here, I’m gonna use abstract, you know, numbers. But if I have a replication product that the gross performance pre-fee is at the 30th percentile in the hedge fund industry or maybe even the 20th percentile, but the fee is much higher.
Andy: Just for argument’s sake, though, if you’re at the 30th or 25th percentile, and your fee structure is essentially exponentially lower on an after-fee basis, you’re gonna be probably at the median or above the median. And that’s if the performance is kind of low. Now imagine if the performance is average, but the fee structure is dramatically lower.
Andy: I imagine on an after-fee basis, that’s gonna put you around the 85th, 90th, you know, in there, percentile.
Andrew: Yeah. We’re usually in the 95th percentile over time. But it’s two parts, right? So, part number one is you reduce fees, right? So, we can generally replicate between 80% and 100% if there are pre-fee returns depending upon the strategy.
Andrew: And then, we charge a lot less. Our fee savings range anywhere to a couple of hundred basis points depending on the strategy up to about 400 basis points net. But the other element of it is replicating. Just like the S&P 500 is generally a lot less risky than any of the 500 stocks because you get diversification across it. Replicating 20 managed futures funds is generally a lot less risky than trying to pick one of the 20. Replicating. So, what you end up happening is, it’s actually the value investor model about performing, which is, I consistently outperform through fee reduction. And in year one, there’ll be plenty of guys who do better than me, but by year two or three, a lot of those guys have flamed out. And then there’ll be new guys who will do better, and then they’ll flame out.
Andy: That’s pure Jack Boglehead philosophy. So I have to ask, you know, we’ve been talking about the theory, and we’re gonna talk about both ETFs, but I wanted to start with DBEH.
Andy: So, that’s the iMGP DBi hedge strategy ETF. And just reading my notes here, seeks to replicate the pre-fee returns of 40 leading equity long-short hedge funds to deliver equity-like returns over time with less risk. Is that basically, you know, the real-world manifestation of the theory that we’re talking about?
Andrew: Yeah. So, we started to replicate equity long-short as a category in 2012. So, we’ve been doing it now for 10 years, I guess.
Andy: So, this ETF is now a decade old?
Andrew: No, it’s only three years old. So, we launched in [inaudible 00:34:08], and there are slightly different iterations. But we’ve been doing this for a long time. So, I wanna do an aside for a second. What we do does not work with a lot of things.
Andrew: Right. So, in 15 years, we do this with three different strategies, two of which are kind of similar.
Andy: Because PE distressed, you know, or merger arbitrage, all these kinds of hedge fund strategies, they’re not gonna work?
Andrew: They don’t work with what we do. Right. So, in managed futures, they make all of their money on big trades. Were they long or short, the dollar? Were they long or short treasuries? Equity long-short, they make most of their money by, are they pivoting from value to growth? You know, are they adding or de-risking? Are they moving from the US to emerging markets or vice versa? It’s kinda these big factor rotations.
Andrew: Do not try to do this with Millennium, or D. E. Shaw, or merger arb guys, or PE. I mean, there actually are PE replication products out there that do it. But what you basically end up with is a super volatile version of equities, and that’s really not what people want. But the…
Andy: So, the hedge fund, you know, this factor-based replication, it’s not like it’s going to completely replace the hedge fund industry and all the strategies in it. Your firm is really focused on these hedge fund strategies that are best replicated where an ETF really would work. And so, with DBEH, that’s what we’re talking about, is one of those two core strategies which is equity long-short, right?
Andrew: Exactly. It’s equity. So, here’s how I think about equity long-short, right? First of all, from a diversification perspective, these guys are going to be long equities over time. They like picking stocks more than shorting stocks. And so, when you look at the data over time, that your exposure to the markets is around 0.5, basically. The way they add value as a group is that they do make these shifts. So, a great example was in 2020, right? In 2020, these guys made two very, very good shifts. The first was they realized right as we were in April and May, they actually were increasing equity risk, right? So, we’re in the midst of the lockdowns, there’s hysteria and these guys… Now, remember, a lot of these guys, or most of these guys know every company that they own like the back of their hands, right? And they’re looking at this and they’re looking at the state of the world and saying, the markets have gone extreme. And plus, the Fed has dropped rates. We’re seeing fiscal backing, we’re seeing all these different things happening. So, what the world, a lot of people were saying, you know, we had had a bit of a balance, but we’re gonna go right back down into the abyss, these guys were adding equity risk. That’s a kind of a factor rotation. It’s not, I added risk on Monday and the markets went up. It’s, more strategic equities were becoming more attractive given what’s happening to interest rates.
The other thing is, though, that a lot of them had been huge buyers of FAANG stocks. And you’re hearing stories today about the guys who were really out over their skis on tech stocks. But a lot of guys had exposure. In fact, the most popular hedge fund positions were FAANG stocks and stocks like it. Because these guys, you know, again, from a bottom-up perspective in the 2010s, had realized that these guys had the most incredible business plans they’d ever seen. I mean, Warren Buffet, who, you know, before he bought Apple, basically, he said, he couldn’t believe he missed Google. And he said it’s like somebody invented a cash register and put it in San Francisco, and anytime anybody went online anywhere, the cash register rang, you know. And so, hedge funds were pretty early in the 2010s, and realizing these business models could keep compounding at rates far beyond what people were expecting. But then, coming out of the COVID crisis, all those stocks went up, right? So, it was the weirdest brief bear market that nobody expected. And that the value stocks which already were highly valued… Sorry, the growth stocks, which already had high valuations, and the value stocks, which had historically low valuations relative to the value stocks, it went further.
Andrew: The growth stocks went up more and the value stocks went down. So, these guys going into the summer, were basically saying like, do I wanna add more to my Microsoft position that’s now gone up 60% or something in three months and is now 10% of my portfolio? Or do I wanna buy that cruise line over there that I don’t think is gonna be liquidated and bankrupt, and it’s gonna come back at some point? You know, do I wanna buy that regional bank? Do I wanna buy that commodity producer? And so, what we saw in the models was this migration into value. And again, the way that we see it in our portfolios is not that they’re buying this stock or that stock, but it’s rather these kind of big rotations. And so, they shift from, you know, NASDAQ, or we don’t see NASDAQ growing as they’re increasing their allocations, but all of a sudden, we see U.S. small-caps going. Well, U.S. small-caps have more oil and gas companies, banks, retailers, things like that, that you would kind of expect to see in a more value-based portfolio.
So, the idea of equity long-short is, you know, people love to talk about this guy owns this stock, and why he’s gonna be right. And there there’s huge value from that advisors and family office people often get from reading the letters because they’re great stories, it sounds. You get a sense into how people are thinking. But from a model allocation perspective, that stuff doesn’t really matter. What matters is you have something that compliments your portfolio. So, I view equity long-short as being able to deliver with about half the risk of the equity markets. The goal is to generate about 200 basis points of excess returns over time net of fees. And if you can do that, then that’s 200 basis points of alpha, and then it has a role in a diversified portfolio. And it goes from the equity allocation into that.
Andy: Yeah. Typically, that kind of strategy available in a hedge fund to institutional investors or ultra-high net worth, large family offices with very high investment minimum. So, what this ETF is doing is essentially, you know, bringing that liquid product to market, making it accessible to retail investors. So, you know, frankly, that’s amazing and is how much innovation has occurred in the ETF world in the past 10 years. And Andrew, I want to put a pin in our conversation here because for our viewers and listeners, I want to talk about Andrew’s other ETF as well and the other strategy. So, we’re gonna bring Andrew back for part two of our episode, talking more about hedge funds as well as managed futures. So, be on the lookout for that episode coming shortly.