‘Replicators’ operate very differently from most hedge-like portfolios

A handful of mutual-fund companies say they’ve built a better mousetrap when it comes to investing like a hedge fund. But for investors, these funds require a very close look under the hood.

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For many years, mutual funds struggled to compete with hedge funds, private investment partnerships that often offered better returns across both market ups and downs thanks to their esoteric strategies. Many mutual-fund companies have taken a page straight from the hedge-fund playbook and are offering funds that can profit when stocks and bonds fall. Others trade currencies and use complex derivatives.

But a few fund companies are taking a very different—and unusual—approach. They employ so-called hedge-fund replication strategies, and they aim to deliver the same kinds of returns available among hedge funds, but without making the actual investment decisions behind those numbers.

Looking Backward

These strategies rely on computer programs that essentially drive looking in the rear-view mirror. Computer models evaluate past returns of hedge funds, either across the entire industry or by specialty. Then the fund managers attempt to assemble a portfolio of stocks, bonds and other investments that when combined, would have produced the same pattern of returns.

A few have gotten investors’ attention. Goldman Sachs Absolute Return Tracker has $1.8 billion in assets. Natixis ASG Global Alternatives holds $1.4 billion. IndexIQ manages roughly $440 million in four funds, three of which are exchange-traded funds. Credit Suisse Group and Rydex/SGI also have replicator offerings.

For the retail investor, it is as good a way as any to access the return streams of the hedge-fund universe, says Lane Jones, chief investment officer at financial advisers Evensky & Katz in Coral Gables, Fla. The firm has client money in Natixis ASG Global Alternatives. The appeal: far lower fees than most hedge funds, transparency of holdings and ease of access to money if it needs to be withdrawn, he says. It’s a format that solves a lot of the problems you typically don’t like about hedge funds, he says.

ENLARGE

But the concept behind hedge-fund replication strategies is odd; imagine a mutual fund where the portfolio manager buys stocks and bonds based on last month’s moves in the markets. Hedge-fund replication models look at hedge-fund returns and then try to match them up with returns on different kinds of investments—for instance, a mix of big-company U.S. stocks, European bonds, currencies and gold. The models then construct a portfolio using futures contracts and index-based ETFs or, in some cases, derivative contracts.

But even if a replicator fund does manage to exactly reproduce the contents of a hedge fund from the previous month, there are no guarantees the two funds will have similar returns in the next month, since the hedge fund can change its holdings any time. Moreover, a replicator fund can’t reproduce the thinking of the hedge-fund manager. Replicator funds, unlike hedge funds, are essentially passive, index-based strategies.

You potentially lose the active-management benefit of picking good hedge-fund managers, says Evensky’s Mr. Jones. It comes with some give-up.

One replicator-fund manager doesn’t see this as a major hurdle. While a hedge fund may distinguish itself by stock picking, a not trivial portion of its returns is due to the stock market in general, rather than the individual stock, says Jerry Chafkin, president of AlphaSimplex Group LLC and co-manager of Natixis ASG Global Alternatives and other funds under the Natixis ASG name. What we’re trying to do is identify the broad market exposure that explains a significant percentage of the return of hedge funds.

This approach hasn’t won over Heritage Financial Services in Norwood, Mass. The firm prefers mutual funds that employ hedge-fund strategies or provide direct access to hedge-fund managers, says Michael McIntosh, a Heritage Financial analyst. However, we don’t believe that investing in a hedge-fund index will add value, he says.

Mr. McIntosh also avoids the funds, he says, because they try to reproduce returns that are at least a month old.

Executives at the firms managing hedge-fund replicators say that over the long term, funds are able to track the returns of hedge-fund indexes despite their reliance on old return data.

In part that’s because while some hedge-fund managers make frequent changes to their portfolios, overall the broad market exposures tend to evolve slowly and steadily, says Mr. Chafkin.

Faster Moves

But that may not be the case in the kind of volatile markets seen in the past year. Faced with significant global uncertainties, traders say, hedge funds have been quicker to get in and out of positions; many went aggressively into cash in just a span of weeks during the early summer.

Critics also question the quality of the return information itself. Adam Patti, chief executive at IndexIQ, concedes that with hedge funds we are dealing with incomplete information, he says. Hedge-fund indexes are composed of individual hedge funds that, while audited, are notorious for overstating returns and understating volatility by not marking to market properly.

Still, he says, our hedge-fund replication products are being compared against a benchmark that, while flawed, is the best we have in the market…and if we can provide performance similar to it, we are actually doing quite a bit better than the average hedge-fund manager given the overstating of performance.

Another issue is that while investors may have transparency into the holdings of a replicator fund—especially on ETF versions, which give daily access—there’s little predictability about what the fund will look like in the future or how it may behave.

And performance can be all over the map. In the third quarter, Hedge Fund Research Inc.’s HFRI Fund of Funds index, an industry benchmark, fell 4.7%. Meanwhile, Natixis ASG Global Alternatives lost 7.5%, the IQ Hedge Multi-Strategy Tracker ETF lost 2.2%, and Goldman Sachs Absolute Return Tracker fell 6.1%.

Mr. Lauricella is a staff reporter for The Wall Street Journal in New York. He can be reached at tom.lauricella@wsj.com .