Attack of the clones

Investment banks are swamping the market with hedge fund replication strategies which purport to mimic the behaviour of multiple hedge fund strategies, essentially providing similar returns for a much lower cost.

Approaches vary among providers, however the rationale behind them is the same – hedge fund returns often have more to do with underlying market movements than manager skill.

Strategies on offer include the Goldman Sachs Absolute Return Tracker, Merrill Lynch Factor Model, Partners Group Alternative Strategies and Fund Creator.

JP Morgan, Bear Stearns and Deutsche Bank have also launched hedge fund clones, with other firms signalling their intention to enter the market imminently.

So are hedge fund replication strategies a cheap alternative to fund of hedge funds, or an untried and untested product that could well leave investors disappointed?

Two recent reports have challenged the notion that it is possible to replicate hedge fund beta through an index-based approach.

Edhec, the French business school, published a report in June which concluded that none of the hedge fund replication strategies revealed so far can accurately replicate hedge fund returns.

Meanwhile, research by specialist hedge fund consultancy Liability Solutions found the Merrill Lynch Hedge Factor Index (now the Merrill Lynch Factor Model) and the Partners Group Alternative Strategies underperformed the average fund of hedge fund on a risk adjusted basis net of fees.

The firm also surmised that fund of hedge funds have exhibited far greater downside protection during equity market downturns.

According to the report, the S&P 500 had 14 negative months between January 2003 and February 2007. During this period, the Merrill Lynch product, which has the longest stated track record, recorded a loss in nine of those versus six for the HFR FoHF Index with total losses of 11 per cent and 6.8 per cent respectively.

Phil Irvine, director of advisory services at Liability Solutions, said: “I personally think the more proven aspects of capital preservation in different markets of fund of hedge funds are potentially more attractive at this moment in time.”

Proponents of hedge fund replication claim the strategies allow investors to trade a highly liquid and transparent product that provides cheaper exposure to a large part of the hedge fund universe.

Michel Jacquemai, partner at Partners Group, said a “top down” regression-based replication approach can produce decent returns in a quiet market environment but the “bottom up” approach adopted by his firm, which allows the replication of a basket of numerous individual sub-hedge fund strategies, is more appropriate for replicating beta in periods of high volatility.

“We believe we are able to replicate about two thirds of the hedge fund strategies - the rest can be done via satellites,” he said.

“What you typically can’t replicate are strategies that exploit market inefficiencies, which per definition is producing alpha. That’s the job of the satellite managers. We believe between 70 and 80% of total hedge fund returns can be attributed to alternative risk premium. Hedge fund replication tools collect systematic risk premia by employing hedge fund techniques.”


1 July 2007