Although the hedge fund industry has continued to grow its assets under management, the supposed value these funds offer to investors is being questioned. Much of the original appeal was the idea that actively managed funds would be able to respond to market conditions more quickly and adjust their portfolios to hedge when large stresses hit the market. Interestingly, the research shows that a portfolio made up of exchange-traded products (ETPs) that clones the long–short strategy does an excellent job of producing similar returns. What might be somewhat surprising is that as a group, the long–short equity funds tend to add negative alpha during periods of market volatility—precisely the opposite of what investors would expect them to produce given the nature of their strategies.

At the end of 2013, hedge funds controlled $2.6 trillion, and the long–short funds accounted for the largest single strategy group. The hedge fund industry has grown to mammoth proportions, and the fees generated by the industry are no less astronomical. Not only have many investors begun to question the fees being charged, but they are also beginning to question the value proposition the industry claims to offer. The hedge fund industry has upheld the notion that it offers uncorrelated alpha compared with and not available from more traditional investments, although this argument has been somewhat weakened more recently by the increasing number of liquid alternative investment options that have become available.

In the industry, it is generally believed that a portfolio manager’s returns can be attributed to the manager’s exposure to systematic (beta) and unsystematic (alpha) risk factors. Empirical research done by Eugene Fama and Kenneth French (Journal of Financial Economics 1993) revealed that two additional risk factors (size and value) unaccounted for in the original CAPM could explain much of the outperformance many equity managers claimed was alpha. Since their seminal paper was published, other researchers have found a number of additional risk factors that were once considered alpha.

The author attempts to gain some understanding of the value added from the collective active management decisions of long–short equity hedge funds relative to an investable benchmark that replicates the aggregate factor exposures of the group. By creating a dynamic “clone” portfolio using ETPs, the author is able to build a portfolio that performs as well as the aggregate long–short hedge funds over time while, surprisingly, outperforming the long–short equity funds by upward of 8% (annualized) during market stress. This finding runs counter to what the hedge fund industry would have investors believe—that hedge funds add value during periods of market strain. The results suggest that hedge fund managers would perform better during challenging environments by keeping their core factor exposures stable while avoiding excessive trading.

The analysis covers the group of long–short equity hedge funds that are primarily buying and selling US or Canadian equities. The hedge fund data are pulled from eVestment and cover the period from November 2003 to November 2013; the data are then manually screened for funds that fit the sample criteria.

To create the clone portfolio, the author starts with the entire ETP universe and applies three filters: a liquidity filter to ensure adequate size and trading volume, an economic sensibility filter to eliminate any esoteric funds, and a principal components analysis filter to weed out any superfluous exposures. The clone portfolio is left with 50 ETPs that are able to adequately capture the many risk exposures common across the group of long–short equity funds.

With a replication approach based on rolling factors, the author uses monthly returns of the long–short equity funds with a 24-month look back to determine the ETPs that most accurately capture the long–short equity group’s risk–return profile. Next, using linear regression to establish the proper allocation of ETPs to the portfolio, the author purchases the ETP portfolio in the beginning of each month and subsequently rebalances monthly. He thus replicates the systematic and time-varying exposures of the hedge fund group. Constructing the clone portfolio and analyzing the funds in this way provides a very valuable baseline with which to measure the noninvestable benchmark of active long–short equity hedge fund managers.

As the industry has been analyzing and reflecting on the market’s volatility over the past 15 years, the entire active management community has come under increasing pressure to justify its existence. Several areas are being questioned; fees, transparency, liquidity, and performance are being scrutinized like never before. Several researchers have shown that active management has a difficult time justifying its value; many low-cost alternatives are now available, and the industry has not proved its claims to outperformance. Active management fees have come down, but will it be enough to overcome the performance, transparency, and liquidity issues still surrounding the industry?