Harvard Case - ProShares Hedge Replication ETF
"ProShares Hedge Replication ETF" Harvard business case study is written by Pedro Matos, Anil Demir. It deals with the challenges in the field of Finance. The case study is 31 page(s) long and it was first published on : Feb 19, 2015
At Fern Fort University, we recommend that ProShares proceed with the launch of the Hedge Replication ETF, but with a focus on transparency, risk management, and investor education. This strategy will allow ProShares to tap into the growing demand for alternative investment strategies while mitigating potential risks and maintaining investor confidence.
2. Background
The case study focuses on ProShares, a leading provider of exchange-traded funds (ETFs), considering the launch of a new ETF that replicates the returns of hedge funds. This presents a significant opportunity for ProShares to expand its product offerings and cater to a broader investor base seeking alternative investment strategies. However, the case also highlights the inherent challenges associated with replicating hedge fund returns, including the complexity of hedge fund strategies, limited transparency, and potential for significant risk.
The main protagonists of the case study are Michael Sapir, the CEO of ProShares, and John McQuown, the firm's Chief Investment Officer, who are tasked with evaluating the feasibility and potential risks of launching the Hedge Replication ETF.
3. Analysis of the Case Study
This case study can be analyzed through the lens of financial analysis, risk management, and investment management.
- Financial Analysis: ProShares needs to conduct a thorough financial analysis to determine the potential profitability and feasibility of the Hedge Replication ETF. This analysis should include:
- Cost of capital: Determining the cost of capital for the ETF, taking into account the risk associated with replicating hedge fund returns.
- Pricing strategy: Establishing a competitive pricing strategy for the ETF, considering the fees charged by existing hedge funds and other alternative investment vehicles.
- Cash flow analysis: Projecting the potential cash flows generated by the ETF, considering the expected asset allocation, trading costs, and management fees.
- Break-even analysis: Identifying the minimum assets under management (AUM) required for the ETF to be profitable.
- Risk Management: ProShares needs to develop a comprehensive risk management framework for the Hedge Replication ETF, considering the following factors:
- Market risk: The ETF will be exposed to market risk, as hedge fund returns can fluctuate significantly based on market conditions.
- Liquidity risk: The ETF may face liquidity risk if investors decide to redeem their shares, potentially leading to forced selling of underlying assets.
- Operational risk: The ETF will be subject to operational risks associated with managing a complex portfolio of assets and implementing trading strategies.
- Regulatory risk: The ETF will be subject to regulatory scrutiny, particularly in light of the complexity of hedge fund strategies and the potential for conflicts of interest.
- Investment Management: ProShares needs to develop a robust investment management process for the Hedge Replication ETF, considering the following aspects:
- Asset allocation: Determining the optimal asset allocation for the ETF, taking into account the risk tolerance of investors and the investment strategies of the hedge funds being replicated.
- Portfolio construction: Selecting a diverse portfolio of assets that aligns with the investment objectives of the ETF.
- Performance measurement: Establishing clear metrics for tracking the performance of the ETF and comparing it to the performance of the hedge funds being replicated.
- Transparency: Providing investors with clear and concise information about the ETF's investment strategy, risk factors, and performance.
4. Recommendations
ProShares should proceed with the launch of the Hedge Replication ETF, but with a focus on transparency, risk management, and investor education.
- Transparency: ProShares should strive to provide investors with as much transparency as possible regarding the ETF's investment strategy, portfolio holdings, and risk factors. This can be achieved through:
- Detailed fact sheets: Providing detailed fact sheets that explain the ETF's investment strategy, risk factors, and performance metrics.
- Regular reporting: Providing regular reports to investors detailing the ETF's performance, asset allocation, and trading activity.
- Website transparency: Maintaining a website that provides detailed information about the ETF, including its investment strategy, risk factors, and performance history.
- Risk Management: ProShares should implement a robust risk management framework for the Hedge Replication ETF, including:
- Stress testing: Conducting regular stress tests to assess the ETF's performance under different market scenarios.
- Liquidity management: Implementing strategies to manage liquidity risk, such as limiting the number of shares outstanding and establishing a secondary market for the ETF.
- Operational controls: Establishing strong operational controls to minimize the risk of errors or fraud.
- Regulatory compliance: Ensuring compliance with all applicable regulations, including those related to hedge fund transparency and investor protection.
- Investor Education: ProShares should prioritize investor education to ensure that investors understand the risks and complexities associated with the Hedge Replication ETF. This can be achieved through:
- Educational materials: Providing investors with educational materials that explain the ETF's investment strategy, risk factors, and performance metrics.
- Investor webinars: Hosting investor webinars to provide in-depth information about the ETF and answer investor questions.
- Investor conferences: Participating in investor conferences to educate investors about the ETF and its investment strategy.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core competencies and consistency with mission: ProShares has a strong track record in developing and managing ETFs, and the Hedge Replication ETF aligns with its mission of providing investors with access to innovative investment strategies.
- External customers and internal clients: The Hedge Replication ETF caters to the growing demand for alternative investment strategies among institutional and individual investors.
- Competitors: ProShares needs to be aware of the competitive landscape and differentiate its ETF from existing hedge fund replication products.
- Attractiveness ' quantitative measures: The Hedge Replication ETF has the potential to generate significant returns for ProShares, but it is essential to conduct a thorough financial analysis to assess its profitability and feasibility.
- Assumptions: The recommendations are based on the assumption that ProShares can successfully implement a transparent, risk-managed, and investor-focused approach to launching the Hedge Replication ETF.
6. Conclusion
ProShares has a significant opportunity to expand its product offerings and cater to a broader investor base by launching the Hedge Replication ETF. However, it is crucial to prioritize transparency, risk management, and investor education to ensure the success of the ETF and maintain investor confidence.
7. Discussion
Other alternatives not selected include:
- Delaying the launch: ProShares could choose to delay the launch of the Hedge Replication ETF until the regulatory landscape becomes more favorable or until the firm has a more robust risk management framework in place.
- Focusing on a niche market: ProShares could focus on a specific niche market, such as institutional investors or high-net-worth individuals, to minimize the risk associated with the ETF.
- Partnering with a hedge fund: ProShares could partner with a hedge fund to develop and manage the Hedge Replication ETF, leveraging the hedge fund's expertise in alternative investment strategies.
Key risks and assumptions associated with the recommendations include:
- Regulatory uncertainty: The regulatory environment surrounding hedge fund replication is constantly evolving, and ProShares needs to be prepared to adapt to changes in regulations.
- Market volatility: The Hedge Replication ETF will be exposed to market volatility, which could lead to significant losses for investors.
- Transparency challenges: It may be difficult for ProShares to achieve complete transparency regarding the ETF's investment strategy and portfolio holdings, particularly given the complexity of hedge fund strategies.
8. Next Steps
To implement the recommendations, ProShares should take the following steps:
- Develop a detailed business plan: ProShares should develop a detailed business plan for the Hedge Replication ETF, outlining its investment strategy, risk management framework, marketing plan, and financial projections.
- Conduct a pilot program: ProShares could launch a pilot program for the Hedge Replication ETF, allowing the firm to test its investment strategy and risk management framework before launching the ETF to the public.
- Engage with investors: ProShares should engage with potential investors to understand their needs and expectations for the Hedge Replication ETF.
- Monitor performance: ProShares should closely monitor the performance of the Hedge Replication ETF and make adjustments to its investment strategy as needed.
By taking these steps, ProShares can launch a successful Hedge Replication ETF that meets the needs of investors while mitigating potential risks and maintaining investor confidence.
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Case Description
At the start of 2014, Joanne Hill was preparing to present at a conference focused on alternative investments for financial advisers. Exhibit 1 provides selected slides from the presentation. Hill wants to showcase how Hedge Replication ETF (HDG) provided an exposure to hedge funds at low fees, with full transparency and providing daily liquidity. But she had to overcome some resistance in the audience because most hedge fund strategies had underperformed the overall stock market in recent years. Could 2014 be a comeback year for hedge fund strategies?
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