Warren Buffett famously bet that index tracking would outperform hedge fund returns nine years ago. The S&P 500 index tracker compounded at 85.4%. The best performing fund of hedge funds it was wagered against achieved 62.8%.
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients,” Buffett wrote to Berkshire Hathaway backers. “Both large and small investors should stick with low-cost index funds.”
Buffett is right: Sooner or later, everything has to evolve on Wall Street.
Traditional stock and bond investing has evolved over time with no-load funds, index funds and ETFs, all which offer ever more efficient access to the beta of the market.
But alternative strategies for various reasons have not evolved much past their initial incarnations.
Two major catalysts, though, have today’s asset managers scrambling to evolve again:
- Investors are showing a clear preference for passive index vehicles over active management. One out of every $3 invested in U.S. equity funds is managed passively.
- Institutional investors are demanding more efficient access and lower fees from their hedge fund allocations, with more than $80 billion in net outflows in 2016, largely from fund of funds.
Yet, because many institutional investors are already fully allocated to equities and find little appeal in low-yielding bonds, the demand for alternatives is expected to grow in 2017.
But what if you didn’t have to bet hedge funds against index funds? What if you could have both?
In fact, Citi predicts that nearly $1 trillion in hedge fund allocations could move towards alternative indexes as the trend from active to passive continues.
With all these things changing in the market, how can institutional CIOs and other investors ensure they can still capture non-correlated returns without having to suffer underperformance at a 2-and-20 fee, or even 1-and-10?
Since most current indexes either aggregate or replicate hedge fund performance, they can easily run into issues of self-reporting, survivorship bias or flaws in mirroring the return profiles of certain strategies.
An alternative index that’s a real benchmark should capture the risk and return factors common to all managers working in particular strategy — and only those factors.
The first evolution of this type of index is the BRI Long/Short Equity Index (BRILSE). One of a family of coming hedge fund indexes based on years of published academic and economic research. That means it can offer efficient access to alternative beta investors want without the common structural issues or counter-party risk that plague other hedge funds or index products. Because it captures the same risk, it can also serve as a true benchmark for comparable alternative funds.
That kind of benchmark is valuable whether it’s an allocator looking for the right active manager or an active manager wanting to demonstrate and quantify the alpha it produces. But it’s especially valuable if someone is looking to heed Buffett’s warning and can finally get the alternative index they are asking for.
Adam Brass is the founder of BRI Partners, LLC, a creator and licensor of investable beta hedge fund indexes that specializes in research focused on quantifying, analyzing and demystifying the risk and alpha in alternative strategies.
Article By Adam Brass