Replicators were designed to produce cheap hedge fund beta. Emma Oakman finds out how they have fared through a difficult year
Hedge funds have taken a battering over the last year amid tumbling performance, massive redemptions and revelations of huge-scale fraud. Pension schemes have been left grappling with how to reap their benefits without having to compromise on key factors like transparency and liquidity.
As passive equity investments appeared to have regained popularity, replication products, designed to provide hedge fund-like performance through passive beta exposure to liquid assets, were expecting demand to increase in 2009.
Replicators performed significantly better than hedge fund indexes during 2008, but were still sharply negative and institutional investors remained sceptical about their true merits as transparency; comparability and tracking error came into question.
Fearing investors could be lulled into these products under the misunderstanding they were similar to other passive vehicles, experts called for greater exploration of the economic theories behind these strategies.
According to PiRho Investment Consulting, the average 2008 return for hedge fund replicators publishing information on Bloomberg was -12.7% with annualised volatility of 11.1%, compared to -20% and 9.2% respectively for the HFRI Fund of Fund Index.
“In an environment where one of the principal problems has been sudden illiquidity, particularly in hard-to-value assets, it’s not surprising that vehicles using more liquid and ‘mainstream’ asset classes have suffered less,” Nicola Ralston, director and co-founder of PiRho said.
Hedge funds also suffered sudden increases in the cost of leverage and a decrease in its availability, which had significantly less effect on strategies replicating the impact of net rather than gross leverage.
This was borne out by particularly large divergences in replicators’ returns from October as markets absorbed the fallout from Lehman Brothers’ demise and the liquidity shortage became severe.
Were replicators therefore ‘safer’ or better?
“Not if their job is to replicate hedge fund returns, which is what most of them claim to be targeting,” Ralston said.
Robert Howie, principal at Mercer, argued: “It should be a red flag if these funds perform better than their benchmarks. While outperformance is usually positive, these strategies are not skill based so there is no comfort here. The deviation can go both ways.”
Two paths to replication
Performance has been mixed with returns ranging from -8.9% to -18.7% and annualised volatility between 3.2% and 15.7%. In part, this was explained by differing objectives.
Two main approaches exist: pay-off distribution replication, which focuses on composing portfolios with the same return probability distribution as hedge funds; and factor replication, which involves constructing portfolios that replicate hedge funds’ exposure to risk factors to reproduce returns.
However, variations occurred even within approaches. According to a recent Man Investments report, there was no clear set of factors for each hedge fund strategy. Different researchers apply different factors, thus producing very different results.
The return patterns pointed Ralston in a different direction, however: “Some replicators are interesting investments in their own right, but they are much more like individual hedge funds themselves than a passive version of the hedge fund industry.”
Other experts shared this view, warning against the view that replicators provided returns in line with the hedge fund industry in the same way passive equity investing would.
The likeness to individual hedge funds was true for other aspects of replicators too, including a lack of transparency and need for greater due diligence.
According to David Schroeder, senior research engineer at EDHEC-Risk: “Contrary to popular belief, increased transparency is not seen as a particularly great advantage of replication products.” A recent survey by EDHEC-Risk revealed 44% of asset managers and institutional investors identified poor transparency as a drawback of passive hedge fund replication.
“Replicators are significantly less transparent than many hedge funds,” Ralston said. “We have been shocked at the level of visibility available to the typical investor. It has not always been straightforward to determine what the fees are, for example, and they vary enormously between products.
“Performance figures have also sometimes been abruptly withdrawn from the public domain as we have seen with some major providers in recent months.”
Furthermore, many replication performance statistics were quoted gross of fees, while the hedge fund indexes they are often compared to are universally net of fees.
“This practice of quoting performance before fees should always be challenged,” Ralston said. “The case for replication products should not need to depend on unfair or irrelevant performance comparisons, particularly when greater transparency is often put forward as one of the advantages of this approach.”
Transparency issues, combined with the diversity of approaches and performance, made selecting replicators more art than science.
According to Howie: “The replication space is very complex with a range of approaches producing a mixed set of results. This makes comparing different products very difficult. Those wanting to invest need to have done a lot of due diligence to ensure they really understand what they are buying.”
He called for further research to clarify the long-term risk premium of hedge fund replication. “Compared to equity, where there is a clear theory about why they deliver long-term returns based on growth and capital, the thinking behind replicators has not been emphasised.”
However, replication still has one major trick up its sleeve, highlighted by considerable hedge fund redemptions during 2008: liquidity.
As they are constructed using highly liquid assets, replication strategies are similarly liquid. Schroeder said: “The main advantage of investing in replication products is their liquidity, believed to be much higher than that of hedge funds.”
According to Richard Owen, head of business development at State Street Global Advisors (SSgA): “Replicators provide daily liquidity while delivering the absolute return stream that trustees are looking for when they move away from equity.”
Ralston said replication strategies provided an interesting answer for investors requiring high levels of liquidity. She warned however that their liquidity was yet to be truly tested.
Owen believed replication could also offer greater defence against volatility than traditional hedge funds as their willingness to pay for protection was higher.
He argued: “Hedge funds charge high fees for returns that are majority derived from leveraged beta. Given the rising cost of leverage and their fee levels, they have to implement high risk strategies in order to generate the returns clients demand.”
Based on his estimates, managers needed to generate returns of around 18% to reach target performance of cash plus 5% after fees and costs. “To get 18% returns requires a lot of risk,” he said.
Therefore hedge funds were less likely to pay for relatively expensive look back strategies designed to reduce correlation to volatile markets and stabilise returns over time.
Owen expected that investors disappointed with hedge funds’ performance would be reviewing allocations in the coming months, which would likely prove advantageous for replication providers.
Commitment to replication
In May Swedish pension fund AP7 said it was switching from fund of hedge funds to replication strategies and halving its overall hedge exposure on the back of “disappointing results.”
Earlier this year, the Universities Superannuation Scheme appointed SSgA to manage a US$200m replication mandate. So far though, few pension funds have announced investments in replicators and many industry players were unconvinced demand would blossom.
Howie argued: “These products have not been tried and tested. Many products also represent the whole universe, which is not really what investors want when they put their money into hedge funds. They prefer to focus on the very best opportunities.”
However he also added, “If replicators can show a reasonable track record through the stressed period, then they will gain credibility and will become more interesting.”
According to Man, however, while hedge funds’ alpha component meant they dynamically adjusted weightings and systematic exposures according to changing market conditions, replication indexes were only adjusted with a time lag as they were based on analysis of previous time periods. As a result they were slow in shifting allocations and identifying new sources of return. Replication programs would therefore likely underperform during a prolonged equity market downturn.
“Very clearly, replication products still have a long way to go before they win broad acceptance,” Schroeder said. Their survey revealed 30% of respondents would never invest in these products versus 15% who had. Many had not come to a conclusion about replication products and preferred to wait until the market had delivered its verdict, he added.
“It is clear that we are very far away from the straightforward world of mainstream passive equity products,” Ralston said, “Where investors decide which index they wish to match and have a realistic expectation of ending up within a few basis points of that index. It’s unsurprising that they would like to believe they are getting something similar in hedge fund replication. In reality, however, they are not.
“Pension funds cannot invest blindly in a replication product safe in the knowledge that they will be broadly matching the return of the hedge fund industry with greater transparency. They should be treated as systematic hedge funds rather than industry replicators and should be approached with considerable care and due diligence.”
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