A survey of hedge fund administrators estimates that, by December 2007, global hedge fund assets had reached $4 trillion (1). According to Hedge Fund Intelligence, which provides hedge fund news and data, global hedge fund assets grew by 27% in 2007 to reach $2.65 trillion (2). Regardless of which number is closer to the truth, the growth of hedge fund assets has been nothing short of remarkable.
Accompanying the recent growth in assets has been great interest and curiosity in a new hedge fund strategy called hedge fund replication. Perhaps sceptical of a crowded market chasing fleeting alpha, or tired of seeing fees of 2% and 20% of gains taken off the top, institutional investors are becoming increasingly aware of the attractions of hedge fund replication, a strategy designed to generate hedge fund-like returns at substantially lower fees, and with liquidity not traditionally available in hedge funds.
Academic research on hedge fund return attribution has uncovered significant risk premium exposures (or beta) in hedge funds. These consist of traditional forms of beta, for example equity, credit, term, small-large, value-growth and currency as well as the more exotic forms representing option-based or dynamic trading strategies. Hedge fund replication synthetically reproduces hedge fund or fund-of-funds returns at a low cost through exposure to these betas. While replicating hedge fund returns in this manner forgoes the manager-specific excess return potential associated with direct hedge fund investment, for some investors the cost savings, liquidity, and avoidance of manager-specific risk make a synthetic hedge fund beta approach an appealing alternative to direct hedge fund exposure. Interestingly, based on a survey conducted in February 2008 by AllAboutAlpha.com and conference producer Terrapinn, the hedge fund industry may not be entirely opposed to this relatively new entrant. The majority of funds of funds respondents see hedge fund replication as a complement to traditional funds. Not surprisingly, hedge funds tended to see the strategy as a competitor.
Demand for uncorrelated absolute return
Institutional demand for uncorrelated absolute return increased dramatically following the broad equity market decline of 2000-2002, which was accompanied by a sustained decline in bond yields. This perfect storm for investors, which reduced the value of equity-dominated portfolios at the same time as the present value of liabilities was increasing, underscored the value of uncorrelated sources of return in investors’ asset allocations. The mounting demand for uncorrelated absolute return together with the attractive historical return of hedge funds through various market environments has sparked a dramatic growth in the hedge fund industry.
While assets have been growing, average hedge fund returns have declined in recent years, reflecting some of the challenges investors have faced in capturing returns in this area. First, reported historical average hedge fund returns are an upwardly biased representation of the returns that are truly available because of survivorship, selection, incubation and liquidation biases. For example, many of the published returns of hedge funds are not actually achievable because the benchmarks consist of only the funds that have survived to the end of a particular period rather than the full opportunity set of funds throughout the entire period. In addition, funds are often selected because they have performed well, and funds that fail are removed from the benchmark prior to their true point of demise. All of these forms of bias, which are common in many manager databases, simply mean that a naïve buyer of hedge funds may do significantly worse than the published benchmarks suggest.
Second, access to the best-performing hedge funds or funds of funds is often limited because funds are closed to new investment. Third, increased competition among hedge fund managers may have reduced the potential to add value in hedge funds. Finally, hedge fund and fund of funds fees as well as incentive fees create an additional return hurdle for the average hedge fund investor.
Understanding hedge funds
Academic research analysing hedge fund returns and risks can be traced back more than a decade. In the early 2000s, much of the research focused on replicating the return streams of individual types of hedge fund strategies such as trend followers or merger-arbitrage. More recently, research has looked at fund of hedge fund returns. The results have found that fund of hedge fund returns can largely be explained by a few common forms of risk premia (beta). Some researchers have also used simple forms of dynamic (or exotic) beta to capture the way in which the average hedge fund or fund-of-funds uses dynamic trading strategies such as trend-following or short-volatility approaches. The dynamic betas can be represented in the modelling process as simple trading strategies that mechanically buy and sell options on certain assets as prices rise and fall.
The research suggests that a combination of relatively few forms of both traditional and exotic beta can successfully explain most of the return volatility of hedge fund indexes. For example, some models have achieved R-squared statistics (a measure of their predictive power, with 100% being the best) of 80-95% in explaining fund of fund index returns. Fung et al. (3), for example, use a combination of the following eight forms of beta to model HFR’s HFRI Fund-of-Fund Index returns.
Standard Betas:
1. S&P 500®
2. Small-cap premium
3. Term premium
4. Credit premium
5. Emerging Markets equity
Dynamic (Exotic) Betas (trading strategies capturing non-linear returns):
1. Government bonds
2. Currencies
3. Commodities
Fung et al. were able to explain the majority of fund of funds return variability with a changing basket of these eight forms of beta. Research therefore seems to imply that fund of hedge fund-like returns can be achieved with reasonable tracking variance through exposure to readily available, liquid instruments.
Replicating hedge fund of funds returns
So, indexing approaches can capture the diversified collection of beta that explains the majority of fund of funds index returns. The beta exposure can be obtained through low-cost, liquid instruments, with the weights adjusted on a regular basis resulting from periodic regression analysis. As new monthly hedge fund of fund returns are reported, the regression analysis can be re-run to capture changes in broad hedge fund exposure. As mentioned, a hedge fund replication strategy will fail to capture any alpha that is present in the fund of funds index returns. However, the research suggests that for the fund of fund index returns there is little, if any, after-fee return in excess of the return implied by the collection of betas revealed in the modelling process.
The modelled returns represent what can be achieved with a synthetic hedge fund beta strategy. They compare favourably with the returns of fund of funds index strategies that invest in a diversified collection of underlying hedge funds that are open and are considered to be representative of fund of funds allocations. For example, a portfolio of betas used in the study by Fung et al. (4), which represents the return of a synthetic hedge fund beta strategy, generated an annualised return of 8.7% for the period tested (August 2003 to June 2006). This compares favourably with the reported HFRI Fund of Funds Index return of 8.4%. However, HFR’s investable HFRX Equal-Weighted Index generated an annualised return of just 3.7% over the same period. The significant annualised return shortfall of the investable hedge fund products (nearly 5%) is due, in part, to the management fees paid to underlying managers. It also reflects the challenge in identifying skilled hedge fund managers that are open to investors. These same challenges may explain the more widespread decline in hedge fund returns in recent years.
There are now a handful of live hedge fund replication strategies being marketed to investors. Many have similar approaches but there are differences, some material, so investors need to do their homework. The performance of real money managed in this manner has shown results similar to the simulations that have been undertaken. While there have been periods of high tracking, for the majority of months since real monies have been managed, the replication strategies have generated performance with the same sign of, and of similar magnitude to, investable hedge fund indexes.
The appeal of synthetic hedge fund beta
Since a synthetic approach to capturing hedge fund beta avoids both the payment of fees to underlying hedge funds and the hedge fund manager selection challenges, a growing number of institutional investors are choosing to utilise this lower-risk, lower-cost route to hedge fund exposure. There are three primary ways an investor may utilise a hedge fund replication strategy.
The first potential use is as a liquidity vehicle within an investor’s overall hedge fund portfolio. This would be a permanent allocation for use in rebalancing. For example, if an investor’s overall hedge fund exposure as a percentage of total assets has dropped due to poor performance, adding hedge fund exposure while maintaining liquidity can be achieved very easily through this strategy. Conversely, if hedge funds have performed well relative to other asset classes and the overall exposure is above target at year end, exposure can be reduced via the replication strategy. And even for fund of fund managers, as indicated in the survey referenced earlier, hedge fund replication can be a useful tool for providing liquidity and managing risk exposures and diversification across absolute return strategies.
The second way of utilising hedge fund replication is as a primary source of hedge fund exposure. This may be part of a core-satellite approach, using the hedge fund beta strategy as a means of ensuring that an investor gets hedge fund “market” returns. Traditional hedge funds or fund of funds can then be used as a means of searching for alpha. This approach is similar to how many investors have embraced the core-satellite or passive and active approaches within their equity exposure.
Lastly, investors can use the strategy solely for temporary purposes. As investors decide, for example, to add hedge fund exposure, a hedge fund replication strategy can be used to get immediate exposure to the asset class while the often lengthy due diligence for traditional managers takes place. Also, just as investors change equity managers from time to time due to poor performance, the need to change hedge fund managers will also arise periodically. A hedge fund replication strategy can be used to maintain equity exposure during the transition. Searching for a new manager may take more time than it takes to get out of a hedge fund, and the liquidity of the old and new manager may not be coordinated, creating the need for a temporary place to “park” the assets.
While the assets being managed in this manner through hedge fund replication are very small relative to the size of the overall asset class, one can expect the proportion to grow as the market matures. Demand for liquidity, return expectations commensurate with cost, and compressed returns are likely to be tailwinds for hedge fund replication. Just as investors utilise passive equity strategies to ensure they capture equity market returns, so too might they turn to hedge fund replication to ensure they achieve, at a minimum, hedge fund “market” returns.
---
1. HFM Week, Dec 5th, 2007, 9th biannual HFMWeek Hedge Fund Administrators Survey
2. Hedge Fund Daily, April 17th, 2008, Global HF Assets Climb 27%
3. AllAboutAlpha.com, February 18 th, 2008, AAA Exclusive: Survey contains some surprises about how hedge fund managers now view “hedge fund replication”
4. Fung, William, Hsieh, David A., Naik, Narayan Y. and Ramadorai, Tarun, “Hedge Funds: Performance, Risk and Capital Formation” (July 19 th, 2006). AFA 2007 Chicago Meetings Paper Available at SSRN: http://ssrn.com/abstract=778124.
May 30th, 2008
This material is for your private information. The views expressed in this commentary are representative of Bailey Bishop through May 30, 2008, and are subject to change based on market and other conditions. The opinions expressed may differ from those of other SSgA investment groups that use different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results. SSgA may have or may seek investment management or other business relationships with companies discussed in this material or affiliates of those companies, such as their officers, directors and pension plans.
This communication is directed at Professional Clients (this includes Eligible Counterparties as defined by the Financial Services Authority) who are deemed both Knowledgeable and Experienced in matters relating to investments. The products and services to which this communication relates are only available to such persons and persons of any other description (including Retail Clients) should not rely on this communication. The information contained within this marketing communication has not been prepared in accordance with the legal requirements of Investment Research. As such this document is not subject to any prohibition on dealing ahead of the dissemination of Investment Research.
Accompanying the recent growth in assets has been great interest and curiosity in a new hedge fund strategy called hedge fund replication. Perhaps sceptical of a crowded market chasing fleeting alpha, or tired of seeing fees of 2% and 20% of gains taken off the top, institutional investors are becoming increasingly aware of the attractions of hedge fund replication, a strategy designed to generate hedge fund-like returns at substantially lower fees, and with liquidity not traditionally available in hedge funds.
Academic research on hedge fund return attribution has uncovered significant risk premium exposures (or beta) in hedge funds. These consist of traditional forms of beta, for example equity, credit, term, small-large, value-growth and currency as well as the more exotic forms representing option-based or dynamic trading strategies. Hedge fund replication synthetically reproduces hedge fund or fund-of-funds returns at a low cost through exposure to these betas. While replicating hedge fund returns in this manner forgoes the manager-specific excess return potential associated with direct hedge fund investment, for some investors the cost savings, liquidity, and avoidance of manager-specific risk make a synthetic hedge fund beta approach an appealing alternative to direct hedge fund exposure. Interestingly, based on a survey conducted in February 2008 by AllAboutAlpha.com and conference producer Terrapinn, the hedge fund industry may not be entirely opposed to this relatively new entrant. The majority of funds of funds respondents see hedge fund replication as a complement to traditional funds. Not surprisingly, hedge funds tended to see the strategy as a competitor.
Demand for uncorrelated absolute return
Institutional demand for uncorrelated absolute return increased dramatically following the broad equity market decline of 2000-2002, which was accompanied by a sustained decline in bond yields. This perfect storm for investors, which reduced the value of equity-dominated portfolios at the same time as the present value of liabilities was increasing, underscored the value of uncorrelated sources of return in investors’ asset allocations. The mounting demand for uncorrelated absolute return together with the attractive historical return of hedge funds through various market environments has sparked a dramatic growth in the hedge fund industry.
While assets have been growing, average hedge fund returns have declined in recent years, reflecting some of the challenges investors have faced in capturing returns in this area. First, reported historical average hedge fund returns are an upwardly biased representation of the returns that are truly available because of survivorship, selection, incubation and liquidation biases. For example, many of the published returns of hedge funds are not actually achievable because the benchmarks consist of only the funds that have survived to the end of a particular period rather than the full opportunity set of funds throughout the entire period. In addition, funds are often selected because they have performed well, and funds that fail are removed from the benchmark prior to their true point of demise. All of these forms of bias, which are common in many manager databases, simply mean that a naïve buyer of hedge funds may do significantly worse than the published benchmarks suggest.
Second, access to the best-performing hedge funds or funds of funds is often limited because funds are closed to new investment. Third, increased competition among hedge fund managers may have reduced the potential to add value in hedge funds. Finally, hedge fund and fund of funds fees as well as incentive fees create an additional return hurdle for the average hedge fund investor.
Understanding hedge funds
Academic research analysing hedge fund returns and risks can be traced back more than a decade. In the early 2000s, much of the research focused on replicating the return streams of individual types of hedge fund strategies such as trend followers or merger-arbitrage. More recently, research has looked at fund of hedge fund returns. The results have found that fund of hedge fund returns can largely be explained by a few common forms of risk premia (beta). Some researchers have also used simple forms of dynamic (or exotic) beta to capture the way in which the average hedge fund or fund-of-funds uses dynamic trading strategies such as trend-following or short-volatility approaches. The dynamic betas can be represented in the modelling process as simple trading strategies that mechanically buy and sell options on certain assets as prices rise and fall.
The research suggests that a combination of relatively few forms of both traditional and exotic beta can successfully explain most of the return volatility of hedge fund indexes. For example, some models have achieved R-squared statistics (a measure of their predictive power, with 100% being the best) of 80-95% in explaining fund of fund index returns. Fung et al. (3), for example, use a combination of the following eight forms of beta to model HFR’s HFRI Fund-of-Fund Index returns.
Standard Betas:
1. S&P 500®
2. Small-cap premium
3. Term premium
4. Credit premium
5. Emerging Markets equity
Dynamic (Exotic) Betas (trading strategies capturing non-linear returns):
1. Government bonds
2. Currencies
3. Commodities
Fung et al. were able to explain the majority of fund of funds return variability with a changing basket of these eight forms of beta. Research therefore seems to imply that fund of hedge fund-like returns can be achieved with reasonable tracking variance through exposure to readily available, liquid instruments.
Replicating hedge fund of funds returns
So, indexing approaches can capture the diversified collection of beta that explains the majority of fund of funds index returns. The beta exposure can be obtained through low-cost, liquid instruments, with the weights adjusted on a regular basis resulting from periodic regression analysis. As new monthly hedge fund of fund returns are reported, the regression analysis can be re-run to capture changes in broad hedge fund exposure. As mentioned, a hedge fund replication strategy will fail to capture any alpha that is present in the fund of funds index returns. However, the research suggests that for the fund of fund index returns there is little, if any, after-fee return in excess of the return implied by the collection of betas revealed in the modelling process.
The modelled returns represent what can be achieved with a synthetic hedge fund beta strategy. They compare favourably with the returns of fund of funds index strategies that invest in a diversified collection of underlying hedge funds that are open and are considered to be representative of fund of funds allocations. For example, a portfolio of betas used in the study by Fung et al. (4), which represents the return of a synthetic hedge fund beta strategy, generated an annualised return of 8.7% for the period tested (August 2003 to June 2006). This compares favourably with the reported HFRI Fund of Funds Index return of 8.4%. However, HFR’s investable HFRX Equal-Weighted Index generated an annualised return of just 3.7% over the same period. The significant annualised return shortfall of the investable hedge fund products (nearly 5%) is due, in part, to the management fees paid to underlying managers. It also reflects the challenge in identifying skilled hedge fund managers that are open to investors. These same challenges may explain the more widespread decline in hedge fund returns in recent years.
There are now a handful of live hedge fund replication strategies being marketed to investors. Many have similar approaches but there are differences, some material, so investors need to do their homework. The performance of real money managed in this manner has shown results similar to the simulations that have been undertaken. While there have been periods of high tracking, for the majority of months since real monies have been managed, the replication strategies have generated performance with the same sign of, and of similar magnitude to, investable hedge fund indexes.
The appeal of synthetic hedge fund beta
Since a synthetic approach to capturing hedge fund beta avoids both the payment of fees to underlying hedge funds and the hedge fund manager selection challenges, a growing number of institutional investors are choosing to utilise this lower-risk, lower-cost route to hedge fund exposure. There are three primary ways an investor may utilise a hedge fund replication strategy.
The first potential use is as a liquidity vehicle within an investor’s overall hedge fund portfolio. This would be a permanent allocation for use in rebalancing. For example, if an investor’s overall hedge fund exposure as a percentage of total assets has dropped due to poor performance, adding hedge fund exposure while maintaining liquidity can be achieved very easily through this strategy. Conversely, if hedge funds have performed well relative to other asset classes and the overall exposure is above target at year end, exposure can be reduced via the replication strategy. And even for fund of fund managers, as indicated in the survey referenced earlier, hedge fund replication can be a useful tool for providing liquidity and managing risk exposures and diversification across absolute return strategies.
The second way of utilising hedge fund replication is as a primary source of hedge fund exposure. This may be part of a core-satellite approach, using the hedge fund beta strategy as a means of ensuring that an investor gets hedge fund “market” returns. Traditional hedge funds or fund of funds can then be used as a means of searching for alpha. This approach is similar to how many investors have embraced the core-satellite or passive and active approaches within their equity exposure.
Lastly, investors can use the strategy solely for temporary purposes. As investors decide, for example, to add hedge fund exposure, a hedge fund replication strategy can be used to get immediate exposure to the asset class while the often lengthy due diligence for traditional managers takes place. Also, just as investors change equity managers from time to time due to poor performance, the need to change hedge fund managers will also arise periodically. A hedge fund replication strategy can be used to maintain equity exposure during the transition. Searching for a new manager may take more time than it takes to get out of a hedge fund, and the liquidity of the old and new manager may not be coordinated, creating the need for a temporary place to “park” the assets.
While the assets being managed in this manner through hedge fund replication are very small relative to the size of the overall asset class, one can expect the proportion to grow as the market matures. Demand for liquidity, return expectations commensurate with cost, and compressed returns are likely to be tailwinds for hedge fund replication. Just as investors utilise passive equity strategies to ensure they capture equity market returns, so too might they turn to hedge fund replication to ensure they achieve, at a minimum, hedge fund “market” returns.
---
1. HFM Week, Dec 5th, 2007, 9th biannual HFMWeek Hedge Fund Administrators Survey
2. Hedge Fund Daily, April 17th, 2008, Global HF Assets Climb 27%
3. AllAboutAlpha.com, February 18 th, 2008, AAA Exclusive: Survey contains some surprises about how hedge fund managers now view “hedge fund replication”
4. Fung, William, Hsieh, David A., Naik, Narayan Y. and Ramadorai, Tarun, “Hedge Funds: Performance, Risk and Capital Formation” (July 19 th, 2006). AFA 2007 Chicago Meetings Paper Available at SSRN: http://ssrn.com/abstract=778124.
May 30th, 2008
This material is for your private information. The views expressed in this commentary are representative of Bailey Bishop through May 30, 2008, and are subject to change based on market and other conditions. The opinions expressed may differ from those of other SSgA investment groups that use different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results. SSgA may have or may seek investment management or other business relationships with companies discussed in this material or affiliates of those companies, such as their officers, directors and pension plans.
This communication is directed at Professional Clients (this includes Eligible Counterparties as defined by the Financial Services Authority) who are deemed both Knowledgeable and Experienced in matters relating to investments. The products and services to which this communication relates are only available to such persons and persons of any other description (including Retail Clients) should not rely on this communication. The information contained within this marketing communication has not been prepared in accordance with the legal requirements of Investment Research. As such this document is not subject to any prohibition on dealing ahead of the dissemination of Investment Research.
