It has become more widely accepted that a significant portion of hedge fund industry returns are generated through exposures to common factors including both beta factors (equities, bonds, etc) and alternative beta factors (spreads such as credit, default etc). A growing body of academic research has confirmed this, but it took the generally disappointing performance of hedge funds in 2008 for investors to understand that much of the returns they were paying high fees to obtain could be purchased directly at much lower cost. This, combined with concerns over the liquidity and transparency of traditional hedge fund investments, has fuelled the rapid development and growth of hedge fund index products, in particular, synthetic replication products sometimes referred to as hedge fund clones. These products are increasingly being seen as one possible method to “index” the hedge fund industry with low fees and high liquidity. It is, however, very difficult to accurately index an industry whose true composition is blurred by reporting biases, and where alpha still contributes to the benefits of hedge fund investing. Here, we describe the background to, and construction of, a unique approach to indexing hedge funds that combines a core holding of single managers and combines this with a secondary holding of a blend of synthetic replication products to reduce cost and increase liquidity. The result is a low cost and liquid method of capturing returns from the hedge fund industry while at the same time minimising the impact of a single manager event (blowup).



Sources of hedge fund returns
Academic research and empirical evidence indicate that hedge fund returns are broadly separable into four parts: traditional beta, arising directly from the returns of equities, bonds, commodities, etc; alternative beta from factors such as spreads, illiquidity premium, volatility and momentum; exotic beta, from investments such as life settlements, ground rents, shipping, carbon emissions, micro finance etc; and alpha which, in addition to the common definition of manager skill in market timing and security selection, also includes pure arbitrage, and structural alpha from activities like block trading, market making and other information arbitrage activities.

Alpha, once deemed to be the driving force behind the hedge fund industry, now appears to contribute the least to hedge fund returns, and is diminishing due to the increased number of hedge funds and investor capital entering the space. Professor Narayan Naik’s 2006 research is consistent with other findings: on average, 74% of fund of hedge fund returns could be explained by beta factors, with the returns of funds considered to be high-alpha suffering from the rapid expansion of their funds. Recent alpha levels are approximately 40% of pre-2000 levels. Arguably, the industry shakeout of the last 18 months will mean a reduction in risk capital by both hedge funds and banks and therefore the possibility for alpha to become a larger share of total return drivers but it is unlikely to reach levels that invalidate the existing research on hedge fund beta.

If a significant portion of hedge fund industry returns can be attributed to beta/alternative beta factors, then it follows that these can be replicated without the need for investments into hedge fund managers. Of course, not all hedge funds are created equal and not all can be divisible into simple beta factors. Equity long/short returns have proved to be the most easily replicated, with around 80% of returns explained by two alternative beta factors – the market excess return, as defined by the S&P 500 minus treasuries, and a small cap minus large cap spread defined by the Russell 2000 minus the S&P 500. Other strategies, with less market exposure or a more niche proposition, have seen less success with replication. Some very large hedge fund investors have been monitoring the performance of hedge fund clones with great interest and several have already invested sizable proportions of their hedge fund allocations in these products.