Hedge fund replication is a topic often discussed but not always completely understood.
However, going forward, it certainly looks as if replication strategies will play an increasingly important role in the way large institutional hedge funds approach their hedge fund allocations, and the way funds of funds measure their performance, and levy their fees.
This is a revolution that began in the halls of academia, with the likes of Bill Fung and Narayan Naik at London Business School, and David Hsieh of Duke University. Their analysis of the available data collected by the major hedge fund databases showed that 85% of returns observed by the average fund of hedge funds could be attributed to a collection of risk premia of market returns, rather than the active management skills of the hedge fund portfolio managers. These could include equities, credit, bond market duration and market volatility, all of which can be replicated.
In addition, where alpha was being generated, it was frequently being swallowed by fees. What was needed was a low-cost alternative that could mirror the beta generated by hedge funds (sourcing the return data from the industry databases and replicating it with derivative contracts), allowing investors to more accurately gauge which managers were the true alpha generators in the market.
The underlying philosophy of hedge fund replication is that average hedge fund returns can be achieved at significantly lower cost by constructing portfolios using model-based factor exposures. For many investors, the cost savings coupled with the diversified collection of beta and the avoidance of manager-specific risks can make the synthetic hedge fund option an appealing alternative to direct hedge fund exposure.
A rules-based approach
Naik at el have argued that hedge fund returns can be separated into alpha and beta components with beta being that part of the return that stems from the assets and strategies held in the portfolio that rise (or fall) in value regardless of the investment decisions of the manager himself. This is based on William Sharpe’s original 1992 work on linear factor replication, and Bill Fung’s subsequent 1997 proposal that this could be applied to hedge fund returns.
The classic synthetic hedge fund strategy adopts a rules-based approach to simulate the beta component of the return using derivative contracts. This is founded on a factor-based strategy, tracking historical hedge fund returns using liquid assets. A statistical model creates the optimum weightings to emulate the returns of the universe of strategies being tracked. The weightings are updated dynamically as new return information is made available from the various hedge fund databases.
Why not just buy the index? As Bailey Bishop, a Senior Portfolio Manager within SSgA’s Structured Products Division, argues in his article in this special report, reported historical average hedge fund returns are an upwardly biased representation of the returns that are truly available, due to survivorship, selection, incubation and liquidation biases. Some benchmarks, he argues, consist only of the funds that survived, not the entire opportunity set. Funds can be selected for an index because they have performed well, while the failures are removed from the benchmark prior to the true point of their demise. Even in the case of investable hedge fund indices, the investor is unable to capture the returns of those firms closed to new investment.
Hedge fund replication, on the other hand, offers the investor the ability to focus, should he so choose, on the top-performing funds, for instance specifying a top quartile return rather than a larger universe. “This can be tailored on a client-by-client basis,” explains Paul Brakke, Head of Global Structured Products at SSgA.
The arrival of replication offerings was perhaps an inevitable response to some fundamental changes occurring in the complexion of the hedge fund industry. “Alpha opportunities have not kept pace with the size of the industry,” argues Narayan Naik of the London Business School. “Investors are becoming more sophisticated and have less patience.” The hedge fund industry, he points out, has fundamentally changed. Large scale institutional investment has changed the expectation set for hedge fund managers. “Yes, hedge funds try to innovate, but once some strategies become mainstream, the beta component can often be replicated. The more directional it is, the easier it is to capture.”
This, he thinks, will lead to lower fees and transaction costs for investors in some ‘mainstream’ strategies.
Investors are getting on board
Institutional investors are beginning to wake up to the benefits of hedge fund replication. It was in March of this year that the Universities Superannuation Scheme (USS) in the UK handed a US$200 million hedge fund replication mandate to SSgA. It is one of the first UK pension funds to recognise the importance of hedge fund replication as part of its overall alternative investment strategy.
“We are convinced of the merits of hedge fund replication as a way of gaining transparent, liquid, and low-cost exposure to the risk premia that drive the majority of hedge fund returns,” says Michael Powell, Head of Alternatives at the USS.
Independent consultancy JTP Partners worked with Fung and Naik in developing the mandate to meet the specific requirements of the USS. One of the principle concerns for the USS when looking for a replication strategy and designing the parameters of the mandate was mitigating tail risk and significant drawdowns. It looked at traditional measures of risk and returns such as Sharpe ratios, but also focused on higher order moments of the historic returns, such as skew and kurtosis. The attraction of the Fung and Naik approach in particular was the use of look-back straddles to minimise losses during periods of financial market dislocation, such as the past 12 months.
The mandate with SSgA is based on a managed account, giving the USS full transparency on all underlying holdings and transactions. This can involve a significant number of transactions, so JTP Partners has been retained to help with monitoring the portfolio, and verifying how effectively SSgA is implementing the strategy and conforming to the USS risk parameters.
Other institutional investors are also waking up to the possibilities: Swedish public pension plan AP7, which has €9 billion under management, recently told delegates at a Stockholm conference that it was halving its allocation to hedge funds because of disappointing returns. Richard Grottheim, AP7’s Executive Vice-President, said the same returns could be achieved by investing in the risk factors that tend to drive hedge fund returns.
But beyond performance, there are other factors involved in potentially making the switch to replication. In AP7’s case, Grottheim cited ‘media risk,’ having had exposure to collapsed US hedge fund Amaranth in 2006. As a public scheme, headline risk can sometimes consume more resources to defend (see Amaranth), than simply finding a solution that strips this out. And last year’s report by consultancy Casey Quirk backs this up, citing headline risk as the primary reason why non-investors in hedge funds are staying away. Step forward hedge fund replication.
“Return volatility is just one measure of the risk of investing in hedge funds and there are a number of uncompensated risks such as tail risk, liquidity risk and operational risk factors such as fraud, which is exacerbated by lack of transparency,” says Powell at the USS. “Purely focusing on risk-adjusted return measures such as Sharpe ratios fails to take account of these additional risk factors and understates the true risk borne by the investor. Hedge fund replication all but eliminates these risks and arguably delivers superior risk-adjusted returns when all risk factors are taken into account.”
A low risk option
According to SSgA’s Brakke, investing in hedge funds can present institutions with a number of fundamental issues to grapple with, including lack of transparency, limited capacity, specific manager-related risks and higher costs. The hedge fund beta strategy, he says, aims to address those concerns. It also offers clients the opportunity to adopt a core/satellite approach to hedge fund investing.
Increasingly, SSgA’s clients are insisting on separating investment portfolios into alpha and beta returns. The hedge fund beta strategy alone allows them to make a passive allocation to access beta, and to pay only hedge fund-like fees where they can identify genuine hedge fund alpha producers. SSgA’s beta product is called Hedge Fund Beta (in the United States) and Premia Strategy (in Europe), and is aimed at replicating the average performance of a universe of hedge funds through modern indexing techniques based on Messrs Fung, Naik and Hsieh’s analysis of the investment returns of hedge funds.
“It is just an additional tool in an investor’s tool kit,” says the London Business School’s Naik. “You could use it to set fees, or form a passive core that could help you to identify and buy talent. With the more transparent separation of alpha and beta, you should be able to prove where a manager is adding value.”
This is not to say that institutions won’t still invest directly in hedge funds or funds of funds. As Gloria Pilz, founding partner of JTP Partners says, “Those investors who have no, or little, exposure to hedge funds can use replication as a good starting point for their investment into hedge funds and can then add other more specific investments to supplement it.” It still means there is a role to play for those managers who can genuinely add alpha to the equation.
Pilz is echoed by Michael Powell, who says the additional risk factors of hedge fund investing can be mitigated by a robust and comprehensive due diligence process. “We do not see this as a barrier to investing in hedge funds,” he adds.
The early success of hedge fund replication is partly being driven by the increased sums of money being allocated to hedge funds by institutional investors, coupled with a natural preference by those investors for a high degree of transparency and liquidity, something that conventional avenues into hedge funds, like funds of funds, do not offer. Indeed, when last year’s credit crunch only enhanced liquidity issues within hedge fund portfolios and extended lock-ups in many cases, these concerns only increased.
“The benefit of replication strategies is that they employ only liquid strategies such as equity index futures and therefore do not suffer the liquidity risk of some hedge fund strategies,” says Powell at the USS. “Most replication strategies offer at worst weekly liquidity, but the majority offer daily liquidity for investors in significant size transactions. Our most recent mandate with SSgA is a managed account and therefore we own the securities and can liquidate the positions at our discretion.”
Although hedge fund replication has been singled out for criticism in some quarters, it has postulated an attractive alternative approach to hedge fund investing for those institutional investors concerned with a range of the common risk and performance issues associated with hedge funds. While smaller investors will be content to purchase off-the-shelf universe-replicating products, those seeking to make large allocations have the scope now to realise a high degree of transparency and risk management control at a lower price than might have been the case in a fund of funds.
And not only that, but replication also offers investors, including funds of funds, a cheap and cost effective means to mirror the beta in more restricted universes, be it particular sub-strategies or quartiles within the existing databases. Although hedge fund replication is still relatively new as a concept that can actively be invested in, it is one that is rapidly gathering steam, and once longer track records are achieved, we can expect further investor interest.
The rest of this report contains a more in-depth analysis of how replication strategies work, penned by SSgA’s Bailey Bishop, and a Q&A with the founding partners of JTP. It should offer those considering either a more low-risk approach to hedge fund investing, or other ways of replicating beta in one or more hedge fund strategies, a good starting point for their research.
However, going forward, it certainly looks as if replication strategies will play an increasingly important role in the way large institutional hedge funds approach their hedge fund allocations, and the way funds of funds measure their performance, and levy their fees.
This is a revolution that began in the halls of academia, with the likes of Bill Fung and Narayan Naik at London Business School, and David Hsieh of Duke University. Their analysis of the available data collected by the major hedge fund databases showed that 85% of returns observed by the average fund of hedge funds could be attributed to a collection of risk premia of market returns, rather than the active management skills of the hedge fund portfolio managers. These could include equities, credit, bond market duration and market volatility, all of which can be replicated.
In addition, where alpha was being generated, it was frequently being swallowed by fees. What was needed was a low-cost alternative that could mirror the beta generated by hedge funds (sourcing the return data from the industry databases and replicating it with derivative contracts), allowing investors to more accurately gauge which managers were the true alpha generators in the market.
The underlying philosophy of hedge fund replication is that average hedge fund returns can be achieved at significantly lower cost by constructing portfolios using model-based factor exposures. For many investors, the cost savings coupled with the diversified collection of beta and the avoidance of manager-specific risks can make the synthetic hedge fund option an appealing alternative to direct hedge fund exposure.
A rules-based approach
Naik at el have argued that hedge fund returns can be separated into alpha and beta components with beta being that part of the return that stems from the assets and strategies held in the portfolio that rise (or fall) in value regardless of the investment decisions of the manager himself. This is based on William Sharpe’s original 1992 work on linear factor replication, and Bill Fung’s subsequent 1997 proposal that this could be applied to hedge fund returns.
The classic synthetic hedge fund strategy adopts a rules-based approach to simulate the beta component of the return using derivative contracts. This is founded on a factor-based strategy, tracking historical hedge fund returns using liquid assets. A statistical model creates the optimum weightings to emulate the returns of the universe of strategies being tracked. The weightings are updated dynamically as new return information is made available from the various hedge fund databases.
Why not just buy the index? As Bailey Bishop, a Senior Portfolio Manager within SSgA’s Structured Products Division, argues in his article in this special report, reported historical average hedge fund returns are an upwardly biased representation of the returns that are truly available, due to survivorship, selection, incubation and liquidation biases. Some benchmarks, he argues, consist only of the funds that survived, not the entire opportunity set. Funds can be selected for an index because they have performed well, while the failures are removed from the benchmark prior to the true point of their demise. Even in the case of investable hedge fund indices, the investor is unable to capture the returns of those firms closed to new investment.
Hedge fund replication, on the other hand, offers the investor the ability to focus, should he so choose, on the top-performing funds, for instance specifying a top quartile return rather than a larger universe. “This can be tailored on a client-by-client basis,” explains Paul Brakke, Head of Global Structured Products at SSgA.
The arrival of replication offerings was perhaps an inevitable response to some fundamental changes occurring in the complexion of the hedge fund industry. “Alpha opportunities have not kept pace with the size of the industry,” argues Narayan Naik of the London Business School. “Investors are becoming more sophisticated and have less patience.” The hedge fund industry, he points out, has fundamentally changed. Large scale institutional investment has changed the expectation set for hedge fund managers. “Yes, hedge funds try to innovate, but once some strategies become mainstream, the beta component can often be replicated. The more directional it is, the easier it is to capture.”
This, he thinks, will lead to lower fees and transaction costs for investors in some ‘mainstream’ strategies.
Investors are getting on board
Institutional investors are beginning to wake up to the benefits of hedge fund replication. It was in March of this year that the Universities Superannuation Scheme (USS) in the UK handed a US$200 million hedge fund replication mandate to SSgA. It is one of the first UK pension funds to recognise the importance of hedge fund replication as part of its overall alternative investment strategy.
“We are convinced of the merits of hedge fund replication as a way of gaining transparent, liquid, and low-cost exposure to the risk premia that drive the majority of hedge fund returns,” says Michael Powell, Head of Alternatives at the USS.
Independent consultancy JTP Partners worked with Fung and Naik in developing the mandate to meet the specific requirements of the USS. One of the principle concerns for the USS when looking for a replication strategy and designing the parameters of the mandate was mitigating tail risk and significant drawdowns. It looked at traditional measures of risk and returns such as Sharpe ratios, but also focused on higher order moments of the historic returns, such as skew and kurtosis. The attraction of the Fung and Naik approach in particular was the use of look-back straddles to minimise losses during periods of financial market dislocation, such as the past 12 months.
The mandate with SSgA is based on a managed account, giving the USS full transparency on all underlying holdings and transactions. This can involve a significant number of transactions, so JTP Partners has been retained to help with monitoring the portfolio, and verifying how effectively SSgA is implementing the strategy and conforming to the USS risk parameters.
Other institutional investors are also waking up to the possibilities: Swedish public pension plan AP7, which has €9 billion under management, recently told delegates at a Stockholm conference that it was halving its allocation to hedge funds because of disappointing returns. Richard Grottheim, AP7’s Executive Vice-President, said the same returns could be achieved by investing in the risk factors that tend to drive hedge fund returns.
But beyond performance, there are other factors involved in potentially making the switch to replication. In AP7’s case, Grottheim cited ‘media risk,’ having had exposure to collapsed US hedge fund Amaranth in 2006. As a public scheme, headline risk can sometimes consume more resources to defend (see Amaranth), than simply finding a solution that strips this out. And last year’s report by consultancy Casey Quirk backs this up, citing headline risk as the primary reason why non-investors in hedge funds are staying away. Step forward hedge fund replication.
“Return volatility is just one measure of the risk of investing in hedge funds and there are a number of uncompensated risks such as tail risk, liquidity risk and operational risk factors such as fraud, which is exacerbated by lack of transparency,” says Powell at the USS. “Purely focusing on risk-adjusted return measures such as Sharpe ratios fails to take account of these additional risk factors and understates the true risk borne by the investor. Hedge fund replication all but eliminates these risks and arguably delivers superior risk-adjusted returns when all risk factors are taken into account.”
A low risk option
According to SSgA’s Brakke, investing in hedge funds can present institutions with a number of fundamental issues to grapple with, including lack of transparency, limited capacity, specific manager-related risks and higher costs. The hedge fund beta strategy, he says, aims to address those concerns. It also offers clients the opportunity to adopt a core/satellite approach to hedge fund investing.
Increasingly, SSgA’s clients are insisting on separating investment portfolios into alpha and beta returns. The hedge fund beta strategy alone allows them to make a passive allocation to access beta, and to pay only hedge fund-like fees where they can identify genuine hedge fund alpha producers. SSgA’s beta product is called Hedge Fund Beta (in the United States) and Premia Strategy (in Europe), and is aimed at replicating the average performance of a universe of hedge funds through modern indexing techniques based on Messrs Fung, Naik and Hsieh’s analysis of the investment returns of hedge funds.
“It is just an additional tool in an investor’s tool kit,” says the London Business School’s Naik. “You could use it to set fees, or form a passive core that could help you to identify and buy talent. With the more transparent separation of alpha and beta, you should be able to prove where a manager is adding value.”
This is not to say that institutions won’t still invest directly in hedge funds or funds of funds. As Gloria Pilz, founding partner of JTP Partners says, “Those investors who have no, or little, exposure to hedge funds can use replication as a good starting point for their investment into hedge funds and can then add other more specific investments to supplement it.” It still means there is a role to play for those managers who can genuinely add alpha to the equation.
Pilz is echoed by Michael Powell, who says the additional risk factors of hedge fund investing can be mitigated by a robust and comprehensive due diligence process. “We do not see this as a barrier to investing in hedge funds,” he adds.
The early success of hedge fund replication is partly being driven by the increased sums of money being allocated to hedge funds by institutional investors, coupled with a natural preference by those investors for a high degree of transparency and liquidity, something that conventional avenues into hedge funds, like funds of funds, do not offer. Indeed, when last year’s credit crunch only enhanced liquidity issues within hedge fund portfolios and extended lock-ups in many cases, these concerns only increased.
“The benefit of replication strategies is that they employ only liquid strategies such as equity index futures and therefore do not suffer the liquidity risk of some hedge fund strategies,” says Powell at the USS. “Most replication strategies offer at worst weekly liquidity, but the majority offer daily liquidity for investors in significant size transactions. Our most recent mandate with SSgA is a managed account and therefore we own the securities and can liquidate the positions at our discretion.”
Although hedge fund replication has been singled out for criticism in some quarters, it has postulated an attractive alternative approach to hedge fund investing for those institutional investors concerned with a range of the common risk and performance issues associated with hedge funds. While smaller investors will be content to purchase off-the-shelf universe-replicating products, those seeking to make large allocations have the scope now to realise a high degree of transparency and risk management control at a lower price than might have been the case in a fund of funds.
And not only that, but replication also offers investors, including funds of funds, a cheap and cost effective means to mirror the beta in more restricted universes, be it particular sub-strategies or quartiles within the existing databases. Although hedge fund replication is still relatively new as a concept that can actively be invested in, it is one that is rapidly gathering steam, and once longer track records are achieved, we can expect further investor interest.
The rest of this report contains a more in-depth analysis of how replication strategies work, penned by SSgA’s Bailey Bishop, and a Q&A with the founding partners of JTP. It should offer those considering either a more low-risk approach to hedge fund investing, or other ways of replicating beta in one or more hedge fund strategies, a good starting point for their research.
