Elizabeth Pfeuti looks at hedge fund replication vehicles to see how they compare to the hedge funds they endeavour to copy and the funds of funds whose client base they wish to share
The simple answer is no, but the real answer is more complex.
Despite the misleading title, unlike genuine hedge funds, which have historically strived for high alpha, replication techniques were only designed to create beta or at least match the average industry return. However, it is hard to see whether they have even been able to achieve this.
Liability Solutions, a specialist consultancy service which carries out fund of hedge fund research, said it was difficult to fully benchmark how these new products had performed, as return data had become more difficult to access from certain managers of late.
Phil Irvine, director of advisory services, said: "Suddenly from being very open with their results, it is now not possible to get full access to all the funds in this space. It is possible that this is due to poor performance, but of course there is no publicly available evidence to back this up."
This lack of relevant data would seem to be putting some in the pensions industry off allocating money to replication vehicles.
Damian Barry, portfolio manager for alternative investments, Russell, said: "For the moment, the jury's out. I would be interested in seeing how these products reacted to the high volatility environment we had in the summer, as most backwardlooking data would not have prepared them for it."
Giles Drury, senior manager, alternative investment group, KPMG, added: "Pension funds have a fiduciary duty to be cautious with their investments. I'm not sure hedge fund replication has proven itself even if intellectually it makes sense."
Partners Group, a leader in the replication field, announced increased inflows to its business over 2007, but as a public firm could not give a split of the products which had brought in the most money or stirred the most interest.
Lars Jaeger, partner, Partners Group, commented: "We cannot complain with the interest we've had in our replication products."
He added: "There are more players joining the market, with investment banks looking into the methodology with increasing enthusiasm."
Adding to the complexity of the product, according to those within the hedge fund replication sphere, this alternative asset class should be separated into two strategies: the factor approach and mechanical trade replication.
Heiko Ebens, equity-linked analyst, Merrill Lynch, explained the difference: "The factor approach has its roots very much in academic literature and takes its forward movements from backward- looking, general hedge fund data aiming to hit an industry average benchmark.
"Mechanical trade replication focuses on a single strategy and uses the rules a hedge fund manager would, but without resorting to backward-looking data sets."
The appeal of replication techniques
Merrill Lynch was the first to commercially implement the factor approach and is a pioneer in developing the trade replication approach. Ebens highlighted the three characteristics of the products which should in theory make them attractive to pension funds: transparency, cost and liquidity.
Tr a n sp a r enc y, eve r demanded by pension funds, could be one of the main lures to this vehicle. But could it also be one of its downfalls?
What makes hedge funds profitable, in the main, is the originality and skill of the manager. By broadcasting their methodology, the chances of making an alpha return would be significantly cut. So this also draws the question of whether "replication" is really a true description of hedge fund replication techniques.
Chris Mansi, head of fund of hedge funds research, Watson Wyatt, commented: "These replication techniques simply cannot produce such exotic beta as the hedge funds they follow."
This was a view shared by Drury at KPMG, who commented: "As an old hand in the hedge fund industry once told me: in a way it's like trying to replicate a David Beckham free kick. You can create a model to explain his technique, but you can never replicate what he actually does."
Mansi concluded some replication techniques employing a more active overlay could produce better returns, but this would surely impact on Merrill Lynch's second suggested benefit of the vehicle: cost. Merrill Lynch maintained the relatively low performance fees of the replication techniques have come from the absence of an active manager.
As stated by Ebens at Merrill Lynch, the intra-daily liquidity enjoyed by a hedge fund replication vehicle should make it attractive for pension schemes over traditional hedge funds.
Knowing money can be withdrawn at any time could persuade investors to allocate assets to the vehicle. However, after last summer's credit crunch, most hedge funds with lock-in periods reported a better time than some investment houses which allowed clients to pull out their money at the first sign of trouble.
Mansi at Watson Wyatt said: "As replication funds use liquid instruments, they cannot replicate some of the more illiquid strategies that hedge funds invest in."
Replication versus funds of funds
When they first arrived on the scene, it was thought replication techniques would snatch some fund of hedge funds business. This, however, seems not to have happened.
Andrew Lodge, managing director, Nedgroup Investments, commented: "Funds of hedge funds have sharpened up recently, with many now producing alpha.
"We haven't lost clients through replication techniques, but their arrival could be a wake up call for underperforming fund of fund managers who are not producing returns to beat these new competitors," Lodge added.
Chris Jones, CIO, Key Asset Management, added: "Returns from funds replicating hedge funds can go either side of the benchmark; investors could see their investment outperform hedge funds, but equally, if the vehicle was following a different technique, underperformance is a definite possibility. What this goes to show is that there is no guarantee that hedge fund returns can be successfully replicated."
It should not be forgotten, however, that of the thousands of hedge funds in the global market, many of them do not last more than three years, nor are they all stellar performers. With this in mind, would an industry average return base be a good investment option?
Dean Wetton, senior consultant, P-Solve, said a fund of hedge funds would usually be a better choice for pension fund investors.
Wetton said: "Passive replication is not going to be able to create alpha in the long term. Unlike a fund of funds which endeavours to pick the best in the field, replication techniques may not necessarily be exposed to the best part of the industry."
Despite funds of hedge funds being generally more expensive than replication products, Wetton believed where investment products were concerned, pension funds paid for what they got.
Looking at it from a different angle, Barry at Russell said replication products could be used by pension funds comfortable receiving the average return from the hedge fund universe.
Barry commented: "Using replication techniques as a stepping stone towards a more active approach could shed light on some of the array of products offered by hedge funds."
But would investment banks be throwing their hats in this ring if there were no future in hedge fund replication?
Merrill Lynch and Partners Group have shown support for the technique, claiming they have been working on new products.
Ebens at Merrill Lynch said it was developing strategies which would allow investors to buy into specific strategies which could then be bundled up into a fund of fundstype product.
Partners Group said it was looking to create liquid vehicles which could replicate illiquid hedge funds. Jaeger said the incentive to tackle this area had come from investors wanting exposure to the risk profiles and often the resulting high returns generated by hedge funds.
Meanwhile, David Brierwood, chief operating officer, MSCI Barra, commented that even if the technique had been launched as the "great white hope" which would be a source of cheap alpha, this had so far not proved to be the case.
However, like Merril Lynch, he said replication would offer great potential for exploring the myriad techniques offered in the hedge fund universe, from pure micro designs used on a macro level to more general techniques, in fund of fund-style "cocktails" to create high alpha returns.
Brierwood concluded: "Certainly the technique is worth pursuing. In a sense, it's like flying to the moon; it's not the fact that we were able to do it, it was learning the processes and using the side benefits to finetune what we already knew."
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