The future of liquid alts? Goldman’s answer: Replication

Aug 24th, 2018 | By | Category: Alternatives / Multi-Asset

By Andrew D. Beer, Managing Partner of Dynamic Beta Investments, a New York-based liquid alternative specialist and hedge fund advisory firm.

Andrew D. Beer, Managing Partner of Dynamic Beta Investments

Andrew D. Beer, Managing Partner of Dynamic Beta Investments.

Goldman Sachs Asset Management recently filed a registration statement for an alternative ETF that follows a time-tested investment strategy: hedge fund replication. This new ETF comes roughly a decade after Goldman launched a replication-based mutual fund, the Goldman Sachs Absolute Return Tracker (GJRTX) – a mutual fund that has outperformed the HFRX Global Investable Hedge Fund Index (the standard benchmark for many liquid alts products) by 248 bps per annum.

In 2013, Goldman had a different answer: multi-manager mutual funds. The theory here was that a manager (Goldman) could hire talented hedge fund managers to sub-advise specific strategies (equity long/short, macro, etc.) to run managed accounts in a mutual fund structure. Retail investors could then gain access to these managers within the safety of a regulated fund with daily liquidity.  In April 2013, the Goldman Sachs Multi-Manager Mutual Fund (GSMMX) was born.

The selling point of the multi-manager fund was that, despite high fees, these were “real” hedge fund managers who would find ways to deliver alpha. Sure, the fee structure (1.93% after considerable fee waivers) was more than double that of the replication product (0.78% net); however, it was argued, this was a decent price to pay for talent (and a whole lot less than the 2/20 charged by hedge funds themselves).

Despite fanfare and high expectations, over the past five years, GSMMX has delivered less than half the returns of GJRTX, with twice the max drawdown and a Sharpe ratio two thirds lower, yet comparable beta to the MSCI World Index:

Goldman Sachs alternative liquids ETFs

Source: Dynamic Beta Investments.

Remarkably, GJRTX had an upside capture relative to GSMMX of 102% with downside capture of only 57%. As an investment horse race, this was a blowout.

What went wrong? Multi-manager mutual fund managers (as a group – it wasn’t just Goldman) materially underestimated how much alpha managers would lose when seeking to manage portfolios within strict 40 Act constraints on leverage, shorting, derivatives and illiquid assets. Think of mixed martial artists trying to fight boxers without using kicks or holds. The other issue is fees:  roughly half the underperformance is due to fees. Every dollar overpaid destroys a dollar of alpha.

So why is Goldman now launching a replication-based ETF?  Most obviously, replication has performed far better than almost any other category of liquid alternatives. In fact, while most liquid alts underperform illiquid hedge funds by 200 bps per annum, replication strategies have delivered approximately 100 bps more of alpha on average than actual hedge funds.

Critically, drawdowns were much lower than actual hedge funds during the financial crisis – outperformance when it mattered most. In addition, replication strategies typically invest in relatively simple portfolios of liquid futures and ETFs, and hence can be managed easily within the constraints of an ETF.

The clincher, though, may be this: advisors and clients got the message. Within two years of the launch of GSMMX, the Fund exploded to $1.8 billion in AUM. A good portion appears to have come from GJRTX, which suffered $1 billion in redemptions around the same time. The higher-cost, but sexier, product was clearly winning the AUM game. Since then, however, those flows reversed and GSMMX’s assets have dropped by over 70% while GJRTX has doubled back to over $2 billion.

This is an object lesson in what has gone wrong in the liquid alts space. Investors often chase new products with no track record based on unsubstantiated marketing hype; hence the wave of inflows into multi-manager mutual funds starting in 2012. As of this year, though, roughly half of those funds have been closed. For a rational investor, earning 2% per annum after 250 bps in fees is simply not attractive.

Despite years of strong performance, replication has long been viewed as “simple” or “boring” compared to more complicated options. While complexity can have great curb appeal, it often does little for performance and can introduce hidden risks, which is a serious issue with leveraged alternative risk premia funds this year. Finally, fees matter – a lot – and should remain at the top of the list of considerations for long term investors.

All of this is part of a seismic shift in the liquid alternatives space. As we wrote in a white paper, Generation Two Liquid Alternatives, investment decisions increasingly are driven by allocators who manage model portfolios. Those allocators need products that meet three criteria: mutual funds or ETFs that can match or outperform actual, illiquid hedge funds; that can do so with the predictability and risk profile of a highly-diversified portfolio; and that can be delivered at low all-in fees.  Goldman’s product is a very positive step in this direction.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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