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Hedge Fund Monthly
Cloning Comes Alive

Narayan Naik, Professor of Finance
London Business School

December 2007


It has been a self-serving idea for hedge fund managers and many will have profited extensively by it. If a hedge fund manager delivers genuine alpha performance, he can charge substantial fees in return. But the problem is that not all hedge fund managers have consistently delivered A-grade – or alpha – returns to investors, despite hanging onto their often inflated fees. Sheep in wolves’ clothing? Professor Narayan Naik of London Business School thinks, based on empirical evidence, that this is the case for many hedge fund managers. Naik says large swathes of investors would be better off investing in a synthetic hedge fund, which cleverly mimics either specific hedge fund strategies or a set of hedge fund indices – but without the industry standard fees of 2% of funds under management plus 20% of profits. “Research evidence clearly demonstrates that hedge fund returns in reality consist of both alpha and beta. However, the fund manager charges the same ‘2-and-20’ percent fee without distinguishing whether it was the alpha or the beta part of his strategy that contributed to this return. And when you’re paying 2-and-20 percent for beta-related risk, well, that’s a lot!”

Investors in hedge funds now increasingly face two separate issues. The first is that there are simply fewer opportunities to create value and therefore justify the hedge fund manager’s existing 2-and-20 fee model. This reflects a withdrawal of governments and central banks from politically inspired policies such as exchange rate convergence, handing opportunities to the likes of financial speculators like George Soros. And secondly, says Naik, the massive growth of the hedge fund community seeking such opportunities inevitably makes it harder to achieve outstanding performance. “Fewer opportunities to create alpha is one concern. The growth of hedge fund assets this decade is another, often reflecting the advice given by consultants to institutional investors such as endowments, charities, pension funds and wealth funds. Their ‘prudent man’ rules require them to diversify, a requirement bolstered by anxieties arising from the lack of transparency in the hedge fund industry.” This diversification is often solved by outsourcing it to a fund of hedge funds (FoHF) manager says Naik. But only in theory: in practice, two problems emerge. “Firstly, the FoHF manager adds another weighty layer of fees to those already imposed, further diminishing any alpha produced. The second is more subtle but important: it’s the basic arithmetic around FoHF portfolios. The larger the number of managers, the more their shared risks dominate the end investor’s experience. So as more managers get appointed, the more likely the portfolio contains predominantly systematic or beta risks.”


Synthetics Funds – A Cost-Effective Alternative

Synthetic funds, however, could well be another route. Professor Naik and his colleagues at London Business School have pioneered hedge fund research for the last decade, isolating and replicating underlying market factors for specific hedge fund strategies. This research has laid the foundation of accessing the “alternative” beta part of hedge fund returns, but without having to pay hefty fees to the hedge fund managers. The beauty of a synthetic fund is transparency and cost. The synthetic fund cleverly mimics the returns of a diversified portfolio of hedge fund strategies. And compared to many hedge fund fees, a synthetic fund is far cheaper, so likely to interest institutional investors frustrated with the huge fees wrung from FoHFs. Which rather begs the question, why have investors put up with such huge fees for so long? Naik says many investors have not done themselves favours previously by shying away from negotiating hedge fund fees down when returns were poor. Investors instead walked away by withdrawing capital. “Some of these hedge fund fees actually increased. Certainly the genuine alpha producers do deserve this fee hike, but unfortunately that is used as a norm by others too.”

So, are synthetics really a genuine low-cost alternative? A rash of investment banks, amongst them Goldman Sachs, Merrill Lynch, JPMorgan, Bear Stearns and Barclays certainly appear to think so. All have released synthetic hedge fund products that provide the alternative-beta-based component of the returns of hedge fund strategies at a much-reduced client cost. Ushering synthetic hedge funds into the mainstream is also a recognition by the investment banking community that pure alpha performance from traditional hedge fund managers is not always due to the brilliance of a particular hedge fund manager. Rather, strong hedge fund performance can also be attributed to prevailing market conditions – and some hedge fund managers are simply better at taking advantage of such conditions and currents than others, so goes Naik’s thesis. No magic bullet. No exotic winning strategy. “A successful hedge fund strategy would not do so well if the information leaks out. If there’s an original strategy, of course they don’t want to publicise it. But many funds, like pension funds, are demanding more transparency.”

Hedge fund investors too are becoming, rightly so, more discerning. The sheer numbers of funds – it’s estimated there are between 6,000 and 8,000 hedge funds operating worldwide – is beginning to create a more defined hinterland between alpha and beta performers. This hinterland, believes Naik, can only swell as the chances for hedge fund managers to drive real, discernible gains diminish. When George Soros shorted US$10 billion as the Bank of England struggled – and failed – to shore up the British pound in September 1992, Soros at least had the opportunity to make such gains because interventionist forces such as the Bank of England had a clearly defined role to play in the market. Since these market mechanisms have become less pivotal, opportunities have declined, which means pure alpha performance increasingly depends on how a fund manager’s strategy is mixed and blended.

Performance Gap Narrows – And Competition Heats Up

Professor Naik readily acknowledges that a synthetic fund is never going to achieve true alpha grade performance. “You’re always going to be a step behind, but historical data analysis shows you really don’t lose much by that. The reason synthetic hedge funds produce returns of a comparable magnitude is that the manager charges the 2-and-20 percent incentive fee for both alpha and beta performance. If you can save on the 2-and-20 percent charged for the beta component, the cost of not having alpha can be more than offset in a large number of cases.”

So, the hedge fund industry could well be ripe, then, for a wave of consolidation, shaking out weaker players as more quantifiable research is able to separate genuine alpha from beta. “You will see a shake-out,” predicts Narayan. “Those with genuine alpha performance will be able to increase their fees, so it will mean an end to a one-size-fits-all contract that the industry has had more or less up to now. And managers will have to change their strategies to create more alpha. The FoHF managers will have to work harder because of their additional fee layer which takes it close to 3-and-30.”

For example, if investors are expecting a net-of-all-fees return of 10% per annum, then the underlying hedge funds needs to generate a pre-fee return of 16-17% to cover their own fees and the FoHF fees. “If the fund manager is creating a lot of alpha,” says Naik, “then they may be able to justify the 3-and-30 charges. But if alpha is difficult to come by, then the fees are going to hurt investors severely.”

Contrast those charges with those of synthetic funds carrying charges of less than 1%. FoHF, then, may look increasingly exposed on the costs front. In addition, they will never be able to match the excellent transparency, liquidity and capacity of synthetic hedge funds. And unlike hedge funds, synthetic funds carry little operational risk.

Of course, when there is plenty of alpha around, a synthetic fund won’t perform as well, compared with genuine new value created by alpha innovators. Over time, though, it is likely original alpha strategies will be identified and cloned. When alpha performance is properly sustained, it gets scrutinised and replicated. There’s also the concern that as high performing hedge funds become known and attract increasing streams of money, their performance can wilt, and alpha attenuation sets in.

Retail Demand Set to Rise?

Another issue is transparency. As hedge funds become a more accepted part of the financial landscape, particularly with retail investors, demand could well rise. With their greater clarity and lower fees, the case for synthetic funds could become a real alternative for many, particularly for smaller investors mindful of ongoing costs and happy to take some hedge fund exposure as part of a diversified portfolio. And the more alternatives there are, the more competitive the industry should become. Beta performance – hopefully – should sell for a beta price. And alpha performers will be able to charge – more or less – what they like.

True hedge fund innovators, then, will likely have no need for concern. For other less innovative hedge fund managers, they will be under pressure to justify their charging regime. The days when fund managers set up computer-based strategies, then sat back in their chairs are long gone, says Naik. “The competition watches you. Brokers watch you. When you trade with brokers they know when you’re making money, and so they may attempt to follow you. Of course, they follow informed investors. Then this information starts to leak into the market place. George Soros might have hired rocket scientists to evaluate whether the Japanese yen is likely to go up or down. But Soros can’t trade anonymously. He has to call up some dealer at some point and execute that trade.’

The Logical Alternative

The argument, then, for switching to a synthetic-based approach – or at least making synthetics an integral part of your overall portfolio – appears logical. At their simplest, synthetics offers hedge-fund like performance, though not exceptional hedge fund manager performance, without the crippling fees. Their drawbacks, as Naik acknowledges, is that a computer-based synthetic model will never be able to react to new opportunities or conditions in the way an active fund manager can. A computer model can only run along a set track, be it in positive or negative conditions. And they can never contribute true alpha performance because they can only mimic beta. So Naik isn’t arguing synthetic hedge funds are an automatic replacement for exceptional hedge fund performance.

“What I want hedge fund managers to do is to keep innovating, to keep adding value and so therefore justifying their high fees. If they do that then that’s true alpha achieved. But if they’re not adding alpha, yet continue to charge alpha fees, then investors aren’t getting a fair deal. Up to now this sort of comparison between alpha and non-alpha was not quantifiable. Till now the performance fee has been calculated by reference to the return on cash; in future the incentive fee could be calculated by reference to a ‘clone’. This is fairer: an incentive fee is not deserved simply for doing what a synthetic fund can do!”

Box-Out 1: Synthetics Have Protection Built In

Professor Naik says a passive, synthetic fund can contain a look-back straddle, protecting investors from the worst of a downturn. “In the recent past, roughly every four years, the financial markets have been rocked at some point. In February 1994, it was the Fed suddenly increasing interest rates. In 1998, you had the Russian debt default and the LTCM fiasco. In 2001-2002 you had the Enron and Worldcom scandals. These events hurt hedge fund industry returns. But with a synthetic look-back straddle, you get some protection as these pay the difference between the highest and lowest price of an asset.” This was particularly noticeable during the recent market turmoil of July-August 2007, says Naik, when a synthetic fund containing this straddle did not suffer much drawdown.

Box-Out 2: The Race Is On

Getting synthetic hedge funds to market is being actively pursued by Goldman Sachs, JPMorgan, not to mention others. Both companies are using models similar to those proposed by academics, analysing historical monthly hedge fund data and baskets of market indices. Index tracker funds got introduced into the fund management industry 20 years ago. Today these mechanistic low-cost vehicles represent a huge portion of money under management. The big question is: can the hedge fund industry replicate this success with synthetics?



Professor Narayan Naik also teaches the successful Hedge Funds Programme at London Business School which takes place on 17-19 March 2008. For more information on this programme, please click here.




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