Will the hedge fund industry imitate the mutual fund industry by following the path of passive investing? This question is at present one of the hottest in the alternative universe, where the ability to replicate hedge funds is being extensively debated. Whatever the term used – clone, synthetic fund or replication index – this new product is presented as a third generation of products in the passive representation of hedge funds, after non-investable indices and investable indices.
The main arguments are basically the same as those presented by the promoters of investable indices, ie lower costs than individual funds or funds of funds, easier access to the hedge fund universe by lowering the minimum investment level, or better liquidity. Such arguments are genuinely attractive for a new range of investors who did not have the possibility to invest in hedge funds or who were afraid of the black box picture that is often depicted by the media when they talk about hedge funds. These potential new investors and the implied increase in market share in the alternative market undoubtedly explain the launch of self-declared replication programmes by major investment banks.
Competition is fierce, and each new replicator is presented by claiming that the methodology is definitively different and innovative when compared to their competitors. The multiplication of these clones introduces a new challenge that replaces fund picking, namely clone picking. Behind the marketing arguments, it is indispensable for investors to understand what these products really are. Further examination can help them in this salutary task.
Some replication products have been launched by investment banks in association with well-known academics. This is the case of JP Morgan with Fung, Hsieh and Naik, who are members of its Alternative Beta Index committee; of Partners Group with Lars Jaeger; and Merrill Lynch, who underline the academic past of Steve Umlauf, who has taken part in the development of its Factor Index. While the aim is certainly to gain in scientific credibility, it is worth noting that Fung, Hsieh, Naik and Jaeger are some of the authors who have worked on the factor replication approach. Broadly speaking, the method is based on the reconversion of models that were initially dedicated to performance measurement, or more precisely to the distinction between alpha and beta.
The increasing acceptance of the concept of alternative betas and the drift from an alpha-centric view to a beta-centric view have led several academics to try to replicate hedge fund performance by passively reproducing hedge fund exposures. In other words, this kind of replication consists in taking long and/or short positions in a set of factors that best explain the performance of a fund or an index in the in-sample period, and passively holding them in the out-of-sample period. Unfortunately, when out-of-sample results are provided, the explanatory power of the model and the comparison of the returns between clones and their replicated counterparts require that the quality of replication through this method be considered with great care. One of the explanations for the mitigated results is that hedge fund exposures are dynamic. In other words, managers adapt exposures according to the market environment. Products using the aforementioned methodology can consequently suffer from a lack of reactivity, impacting the accuracy of the replication negatively.
Consequently, it is perhaps surprising that in spite of disappointing results in academic studies, the Goldman Sachs Absolute Return Index, the Merrill Lynch Factor Index and the JP Morgan Alternative Beta Index have opted for the factor replication approach. The Goldman Sachs Absolute Return Index uses a pool of 17 factors, including indices related to equities, fixed income, commodities, credit and volatility, and tries to replicate the aggregate position of thousands of hedge funds. The Merrill Lynch Factor Index rebalances, on a monthly basis, the exposures to six factors that are calculated over 24 months: the Standard and Poor’s 500 Index, the MSCI EAFE Index, the MSCI Emerging Markets Free Index, the US Dollar Index, the Russell 2000 Index and 1-month LIBOR. It tries to replicate the performance of the Hedge Fund Research composite index. Kat1 underlines that the index that the Merrill Lynch Factor Index tries to replicate follows “all kinds of strategies” (more precisely 37 sub-strategies). He argues that “the result is an index with mainly traditional risk exposures and very little is ‘alternative’ about it. This is exactly why this index can be accurately replicated2.” But he considers that the traditional exposures of the replicated index are not attractive because they do not give access to one of the main advantages of hedge funds, namely risk diversification. Kat added at an IRC conference in February 2007 that, “factor models can only replicate very well diversified indices, which don’t make very interesting investments”.
The criticism aimed at the replication approach has perhaps led some investment banks to announce that their new replication product offering adds rule-based trading. This method is directly inspired by the work of Mitchell and Pulvino (2001)3. They examine the replication of the Risk Arbitrage strategy from 1963 to 1998, using a database of 4,750 mergers and applying three investment rules when a merger occurs. First, “an investment in any merger cannot exceed 10% of total capital.” Second, the impact of the investment on the price of the underlying securities has to be less than 5%. Third, use of leverage is prohibited.
In the context of hedge fund replication, the goal of the rule-based approach is to capture dynamic exposures to alternative betas. This method has been implemented by Partners Group with its Alternative Beta programme and Merrill Lynch with its Equity Volatility Arbitrage Index. It is interesting to note that at an IRC conference in February 2007, Lars Jaeger, a partner with Partners Group, explained why the factor replication approach does not always work. Jaeger has explored this approach through what he calls “Replicating Factor Strategies”4. According to him, the factor replication approach does not take into account the non-linear payoffs of hedge funds, and it adjusts “to changes in hedge fund exposures with a significant time lag with respect to the investment exposure of hedge funds.” That is why the Alternative Beta programme introduces derivatives and conditional trading rules to replicate hedge funds’ non-linear behaviour. Nevertheless, by using short selling, derivatives and leverage, in other words techniques widely employed by hedge fund managers, this semi-active management implies that such a programme has a lot in common with actual hedge funds. It is therefore fitting that this programme is commercialised with relatively high fees (eg management fees of 1.25% and performance fees of 15%), which is fairly comparable to the standard management fees of 2% and performance fees of 20%. The same remark is valid when applied to the Merrill Lynch Equity Volatility Arbitrage index. Heiko Ebens, who participated in the development of the product, acknowledges5 that the programme executes “similar strategies that hedge funds employ,” by shorting the S&P 500 stock index’s implied volatility. Here cloning does not mean replication of the returns of a fund or an index, but rather replication of a strategy to exploit the same risk premiums. It is the manner in which the funds are managed rather than their results that is reproduced. Unfortunately, this type of systematic trading strategy is known as a semi-active hedge fund and not as a passive clone.
This confusing situation is made worse by the abusive use of the term “clone” in the press. For example, an article announced an “Enhanced clone fund to launch in Japan”6, while in reality the SBI Absolute Return Fund is only a fund invested in two funds, and one of these funds tries to replicate a Hedge Fund Research index by employing similar techniques to hedge funds. AlphaSwiss are more transparent in their marketing. Through their Alternative Beta Approach, they put forward an alternative approach to replication, by exclusively focusing on identifying and investing in alternative betas. This beta-centric approach has the merit of clearly announcing its active management, without trying to disguise its programme as a clone.
The money that can be raised by investment banks via hedge fund replicators undoubtedly explains the nascent multiplication of these products. Moreover, because investors are waiting for passive representation of hedge funds, these products will certainly be successful. Nevertheless, by scrutinising the current offer, we observe that unfortunately no real passive clone is available at present. Further improvements in academic research are required to provide a strong methodical basis for future products.
1 www.allaboutalpha.com, Kat, H., “Why Accurately Replicated Hedge Fund Indices Won’t Do You Much Good”, 3 Mar 2007.
2 According to Merrill Lynch, the correlation with the HFRI Composite Index is 95%.
3 Mitchell, M and Todd Pulvino, 2001, "Characteristics of Risk and Return in Risk Arbitrage”, Journal of Finance, December, pp 2,135-2,175.
4 Jaeger, L and C Wagner, 2005, “Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investments in Hedge Fund Strategies Deliver?”, Journal of Alternative Investments, Winter.
5 www.hedgeworld.com, Merrill unveils new hedge fund replication index, 7 Feb 2007.
6 www.hedgeworld.com, Enhanced clone fund to launch in Japan, 6 Feb 2007.