Matthias Knab reports "live" from the IRC "Hedge Fund Replication and Alternative Beta" conference in Geneva by:http://www.opalesque.com/
With more research and available products, hedge fund replication and alternative beta is catching on. Credit Suisse / Tremont for example believes that "replication is a natural extension of indexing". Click here to read on..
Day Two in Geneva: black swans, a new way to clone and new research on persistence 27 September 2007 http://allaboutalpha.com/blog Taleb: Definitely not a normally-distributed kind of guy Day two was kicked off by a thought-provoking presentation by Nassim Nicholas Taleb, author of several best-selling books about risk, including: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and recently: The Black Swan: The Impact of the Highly Improbable.Please visit http://allaboutalpha.com/blog to see full article with images.
Overheard at the President Wilson 26 September 2007 http://allaboutalpha.com/blog Here are a few more tidbits from the Hotel President Wilson here in Geneva… “I’m thinking about launching an index fund of replicated hedge fund index funds!” John Godden, IGS Group, jokes about a fund of funds to replicate the replicators. Click here to read on..
Hedge Fund Replication: Day One Re-cap 26 September 2007 http://allaboutalpha.com/blog Alpha Male has attended more hedge fund conferences than he cares to remember. Many of them have begun with several empty seats and ended with far more. But apparently the good citizens of Geneva know a hot financial topic when they see one. You know all those seats along the back wall for late comers? Click here to read on..
Heard by the waters of Lake Geneva, 25 September 2007 http://allaboutalpha.com/blog Heard on the floor at Terrapinn’s “Hedge Fund Replication & Alternative Beta” conference in Geneva so far today… “His trading process may be “naive”, but his fees sure aren’t!”- Professor Harry Kat on the hedge fund replication strategy pursued by another well-known firm. Click here to read on..
A Beta Way To Boost HF Returns, From InsitutionalInvestor.com, 21/9/7 The secret ingredient to boosting performance of a hedge fund portfolio is some alternative beta, according to Stonebrook Capital Management. In fact, a first-of-its-kind study conducted for the New York-based firm that specializes in AB, says 30% is about the right mix. Click here to read on..
State Street Quietly Launches Hedge Fund Clone, HEDGEWORLD 18 September 2008 BOSTON (HedgeWorld.com)—State Street Global Advisors is the latest asset manager to launch a hedge fund replicator, following close on the heels of such firms as Goldman Sachs, Barclays and, most recently, Morgan Stanley. The new product has been running since July with seed capital from SSgA. Click here to read on..
T-Rex (Total Return Exposure) strategy to synthetically replicate synthetically HFR Index performance: From Structured Products Online.com: 7 August 2007SGAM AI’s new Ucits fund replicates hedge funds SGAM Alternative Investments (SGAM AI) has launched a Ucits-III compliant mutual fund using the concept of the T-Rex (Total Return Exposure) strategy Click here to read on..
All about Alpha, 15 March 2007, Professor Harry Kat responds to EDHEC study on hedge fund replication After yesterday’s story on EDHEC’s new hedge fund replication research, we were curious about Harry Kat’s take. With some cajoling by us, Professor Kat responds below…By: Prof. Harry Kat, Cass Business School, City University (London). Click here to read on..
Global Pensions, 12 March 2007, Place Your Bets: Investible Indices vs. Replication Strategies
Pension fund demand for hedge fund indices is minimal and the advent of replicator funds could deal a death blow to them, some of the world’s largest consultants have claimed.But FTSE Group alternatives business unit head Gareth Parker insisted passive indices would play “a very big role” in the hedge fund market going forward.Click here to read on..
HEDGEWORLD 13 Feb 2007, Replicators Up Pressure on Manager Fees LONDON (HedgeWorld.com)—Everyone agrees that alpha is like gold dust and perhaps even harder to find. That essential truth helps to underline why about 300 delegates from pension funds, investment banks and consultants, crowded into the Landmark Hotel in Marylebone Monday and Tuesday (Feb. 12, 13) to hear from the leading advocates of hedge fund replication and alternative beta at an event produced by IRC Conferences. Click here to read on..
Daily News, USA, 13 Feb 2007, JP Morgan Debuts Replication Index The hedge fund replication craze continues to spread among investment banks. JP Morgan announced today [Feb. 12] the launch of its Alternative Beta Index (ABI) at a conference in London dubbed Hedge Fund Replication and Alternative Beta. Click here to read on..
All about Alpha 13 Feb 2007, Flying Dutchman Portends Doom for Hedge Fund Industryhttp://www.allaboutalpha.com The Flying Dutchman is a legendary ghost ship that is believed to be a sign of imminent doom for mariners. This fact is surely not lost on Dutchman Harry Kat, who today flew into London’s Landmark Hotel and launched a blistering attack on hedge funds at major hedge fund conference - questioning the industry’s very existence. Click here to read on..
All about Alpha 13 Feb 2007; Merrill Lynch’s Hedge Fund Replication to Go Mass Market http://www.allaboutalpha.com Ben Bowler and Steven Umlauf of Merrill Lynch weren’t going to let JPMorgan’s Lakshmi Seshadri steal the show with her hedge fund replication offering yesterday. Click here to read on..
All about Alpha 13 Feb 2007; Jaeger: Hedge Funds Usher in “Atomic” Age of Investing http://www.allaboutalpha.com You don’t need a Ph.D. in physics to understand hedge fund replication. But Lars Jaeger has one just in case. And he used it masterfully today to draw an analogy between the model of the atom in the 19th century (a random mass of various particles) and the common paradigm understood today including a nucleus (containing most of the atom’s mass) and a number of electrons orbiting it. Click here to read on..
HEDGEWEEK Fri, 09 Feb 2007, Merrill Lynch launches volatility arbitrage index to replicate hedge strategy Merrill Lynch has launched a volatility arbitrage index that seeks to replicate the returns of an S&P 500 volatility arbitrage strategy employed by many actively managed hedge funds. The creation of the index is seen as paving the way for investible products such as exchange-traded funds that track hedge fund performance. Click here to read on..
Jaeger: Replication strategies may account for 40% of managed hedge fund assets next 5 years - From Dailyii.com 15/1/7 In the next half decade, hedge fund replication strategies may account for 40% of managed HF assets, and the drive in that direction is likely to take hold this year Click here to read on..
New Index Trackers Use Hedge Funds As Investing Guide, from the Wall Street Journal, 27/12/2006 Firms such as Merrill Lynch & Co. and Goldman Sachs Group Inc. and a professor at Cass Business School in London have introduced strategies that can be used to track hedge funds or some of the strategies they use -- in effect, offering a passive way to get hedge-fund returns. Click here to read on..
Hedge Funds: Attack of the Clones, BusinessWeek, 5 December 2006 Merrill and Goldman have unveiled index-based products that offer hedge fund exposure at a fraction of the cost. But big-money HF managers shouldn't worry yet. The exotic world of hedge funds may soon look a little more "plain vanilla." Financial companies have recently begun introducing index-based tools that would provide investors with hedge fund exposure for significantly less than hedge fund prices. Click here to read on..
Goldman sets up hedge fund clone, by Steve Johnson, Financial Times Published: Dec 3 2006Goldman Sachs has become the first bank to create a hedge fund replication tool in a move that could lead to a shake-up of the $1,300bn hedge fund industry.The platform will greatly undercut the notoriously high fees of the hedge fund sector. Click here to read on..
Harry Kat and the Art of Replicating Hedge Fund Performance, from www.seekingalpha.com 30/11/2006 There was a lot of press coverage this past week on City University London's Professor of Risk Management and Director of the Alternative Investment Research Centre at the Cass Business School Harry Kat and his recently published papers on replicating hedge fund performance by way of trading futures contracts. Click here to read on..
Hedge-Fund Returns Can Be Matched Without Fees, Professor Says , By Adrian Cox, Nov. 28 (Bloomberg)Hedge-fund investors could earn greater returns at a fraction of the cost, according to research by Cass Business School Professor Harry Kat, who designed software to automatically mimic funds' trading profits. Click here to read on..
Computers 'will replace hedge fund managers'Financial News - 28 Nov 2006 The hedge fund industry is set for a move away from active fund management according to a new report because automated trading systems can outperform real managers.Professor Harry Kat and colleague Helder Palaro from Cass Business School claim to have designed systems that would have outperformed real managers 82% of the time over the past 15 years.Click here to read on..
Replication is the new buzzword, By Steve Johnson Financial Times,Published: November 20 2006 Hedge fund managers have had a ball in recent years, with fund inflows and salaries rising in unison as desperate investors part with generous fees. But is the party about to come to an end for many of the managers who jumped on the hedge fund bandwagon? Click here to read on..
Matthias Knab daily Opalesque newsletter November 16, 2006 Five finance professors to examine new proposed academic hedge fund paradigm `Hedge fund return = traditional beta + alternative beta + alternative alpha`, implications to industry at London `Alternative Beta` event The hedge fund industry is slowly beginning to acknowledge that a large part of its returns arise due to common “risk factors” rather than pure manager skill, i.e. from “alternative beta” rather than alpha. Click here to read on..
Matthias Knab daily Opalesque newsletter November 13, 2006 Dow Jones Indexes is in talks to launch the world's first investable index trackers designed to mimic the behaviour of a range of hedge fund strategies. The artificial trackers would potentially allow investors to access the returns of hedge funds without having to pay the high fees demanded by the industry, typically a 2 per cent annual fee and a 20 per cent performance fee. If successful, the initiative would pose a threat to hedge funds that merely generate the beta of their chosen trading strategy without generating sufficient alpha to justify their high fee structure. Click here to read on..
The Economist - October 26th "Send in the Clones" HEDGE funds profit handsomely from their mystique. The typical client imagines they generate lots of money, doesn't know quite how they do it, and is willing to pay their high fees as a result. But some academics now think it is possible to make cheap, knock-off versions of these expensive originals. Perhaps you can get Saks Fifth Avenue products at street-market prices. Click here to read on..
Taking the ego out of hedge fund investing, Chicago Tribune - October 29th, Gail MarksJarvis Imagine hedge funds without brainy managers maneuvering artfully through short-lived market opportunities day in and day out. You might think the flashy hedge-fund arena could never evolve into this. But with about $1.2 trillion in assets, the industry is maturing. And as it does, analysts are looking for ways to capture the advantages of hedge funds without the tremendous fees and egos that go with the territory. Click here to read on..
Opalesque - October 19th - Merrill Lynch: Rules-based passive hedge fund strategies could provide increasingly attractive alternative to active hedge fund management Rules-based passive hedge fund strategies could provide an increasingly attractive alternative to active hedge fund management as the industry continues to mature according to Merrill Lynch (MER) analysts. They expect strategies will increasingly emerge that aim to replicate hedge fund performance – either by using liquid assets like stocks or by mechanically executing hedge fund strategies – enabling investors to achieve similar returns to hedge funds with lower fees. Investors in such instruments may also benefit from greater liquidity and transparency. Click here to read on..
Matthias Knab reports "live" from the IRC "Hedge Fund Replication and Alternative Beta" conference in Geneva by:http://www.opalesque.com/
With more research and available products, hedge fund replication and alternative beta is catching on. Credit Suisse / Tremont for example believes that "replication is a natural extension of indexing". Matthias Knab reports "live" from the IRC "Hedge Fund Replication and Alternative Beta" conference in Geneva:
Fung: Hedge fund replicators not to replace hedge funds, what`s behind the Black Swans Prof. Bill Fung, BNP Paribas Hedge Fund Centre, London Business School started his "Brief history of hedge fund replication and the origins of alternative beta" introduction with likewise brief definitions, saying that alternative alpha is people investing, and alternative beta is strategy investing as "matured, rule-based strategies whose returns are cheap to replicate"
Fung said replication strategies are not here to replace hedge funds or hedge fund managers. He defines them as a "class of strategies to supplement the existing strategies available to investors".
Risk management, modeled from real hedge funds must be integrated Taking a look at the dynamics of hedge fund replication, Fung said it is imperative for hedge fund replicators to include risk management skills, and not only look at asset classes and strategies. Replicators have to "look at hedge fund managers" and integrate best practice risk management, taking into account liabilities created by leverage. Dynamic allocation of risk capital should be a part of a hedge fund replication. According to Fung, hedge fund replication is a tool "to construct a better portfolio".
Alpha-positive August results (for example JP Morgan and SSGA) show that "it works if you add risk management to your replication strategies", contradicting conventional wisdom usually cited in such months like "when markets go bad, they go bad all together". Giving conventional wisdom a second thought, Fung said following this argument would ultimately mean that diversification does not work, nor short strategies. Or, from another angle, that credit spreads are linked to statistical arbitrage models etc.
Black Swans Addressing the "Black Swan" phenomenon, which is haunting the hedge fund world, Fung said the more you leverage, the more you get black swans. The problem would be intensified as "all hedge funds borrow from the same small group of investment banks."
On each prospectus we print "past performance does not guarantee future results" - yet we all dissect return tables. What for? Conversely, we say "you cannot drive a car staring at the rear mirror" - and yet it is illegal to drive without a rear mirror. According to Fung, we analyze past returns and use rear mirrors "in order to better manage what to come...at the lowest cost." And these cost advantages are the really at the core of all replication efforts.
Gavyn Davies` Fulcrum Asset unveils alternative beta product `Fulcrum Alternative Beta Plus` Gavyn Davies, Chairman of Fulcrum Asset Management, announced his firm is about to launch a hedge fund replicator called Fulcrum Alternative Beta Plus.
20% gross or 14% for 9% net Alternative Beta offers an "efficient fee structure to investors", as well transparency, but not alpha generation. Davis showed that with the accumulation of fees (2+20, 3% transaction costs and 1% costs for "netting off" different parts / submanagers etc.) , a portfolio has to achieve a 20% return so that a 9% yield is produced for the investor. He said an alternative beta portfolio would only have to achieve a 14% gross return, which then gets reduced by 3% transaction cost and a 2% alternative beta fee to the same 9% yield.
We've been through this before Davis said that the asset management industry has "lived through this before" when in the 90'ies indexation and passive investing (e.g. in the mutual fund world) massively change the way assets were run. In our days however, Davis concedes the replication is "much harder to do" in hedge funds than going passive on the S & P 500.
The Fulcrum Alternative Beta Plus ("FAB") combines active trading with a risk stream approach. The active trading component trades about 130 assets based on algorithms, goes long and short etc. Davis said there are two main approaches for obtaining alternative beta in a passive manner, one being the regression approach, which uses rolling regressions over past 24 months against a small number of simple risk streams. Results are used to form a portfolio of risk streams for the month ahead.
The risk stream approach on the other side does not attempt to replicate returns on a month by month basis, but attempts to produce a similar or better pattern of returns and risk than hedge funds over a period of quarters. The risk streams used in this approach are usually greater in number than in the regression approach, and are often far more complex, allowing to build models that "are quite close to what hedge funds do in practice."
Davis says models combining the risk stream and the regression approach can come short, as both approaches display a fairly high correlation. FAB finds the combination of active trading with risk stream more rewarding. In 2007, the FAB produced 5.5 % YTD including August. Backtest return statistics indicated 15.1% net annual return at 7.4% annual volatility and 1.48 Sharpe. The system "works because of the relatively dynamic changes of the equity weightings of the portfolio."
It took Fulcrum "a couple of years" to develop the program. It is intended "to match or improve on hedge fund returns on 12 - 24 months basis", and not to replicate hedge fund returns exactly on monthly basis.
Room for Alternative Beta and hedge FoFs Besides, referring to Bill Fung who showed that hedge funds "aren't great vehicles in meltdowns" - why replicate then when they fall of a cliff, asked Davis. For Fulcrum, "exact hedge fund replication" would not be critical.
Comparing advantages and disadvantages of an alternative beta product versus the FoF approach, Davis said that alpha generation is not necessarily intended for the FAB and "questionable" for FoFs. Alternative Beta of course would provide liquidity, fee advantages and transparency. FoFs on the other side may beat Alternative Beta products in diversification aspects - "even if the FAB invests in 130 assets, you still have one product". Additionally, a good FoF with an experienced and well equipped team may have an an "innovation edge" when it comes to a quick adaption to changing macro parameters or capturing new opportunities. Davis thinks there's room for both vehicles, and "there is no reason to assume that any of these approaches will become so dominant that it will knock out all of the others."
Fulcrum Asset Management LLP was founded by Gavyn Davies and Andrew Stevens in 2004. The firm has a team of 23 who mostly have worked with each other at Goldman Sachs Investment Management.
Hossein B. Kazemi`s White Bear `momentum-matching` hedge fund replicator Hossein B. Kazemi, Managing Partner of Alternative Investment Analytics and Professor of Finance at the University of Massachusetts, introduced a replication model that went live in May 2007. Until about July 25th, his White Bear Partners WBP Equity L/S sort of tracked the S & P 500 and the HFRX, however since that date and until August 22nd, his system held up by a significant margin.
Kazemi said two methods were prevalent for "completing financial markets": 1. Lots of trading (Black.-Scholes) or lots of assets (Arrow-Debreu). Kazemi says that "in a sense Kat and Palaro use the frequent trading approach to complete markets and to replicate hedge fund payoffs. We argue that using "lots of assets", the same goal can be approached by lower costs and higher correlation with the target.
The following are the pillars of this "momentum matching" strategy:
A large set of asset classes is initially considered for investment. Currently, over 30 equity, fixed income and commodity investments are considered. A Multivariate GARCH model is used to estimate the variance-covariance matrix of these asset classes assets periodically The estimated variance-covariance matrix is used the select the most useful asset classes in replicating the benchmark (by reducing the number of assets to 8 to 15) and to estimate optimal weights. Other market factors such as credit spreads, term spread and volatility are used to adjust weights between calibration periods. this allows the model to react on a daily basis to change in the market conditions. His model also delivers interesting insights how through time the different asset classes become important in explaining the return to hedged equity strategy, underlining its momentum-centric characteristics.
In a side note, Kazemi said it may be possible at some point in the future that hedge fund managers may outsmart factor based models, using the models as liquidity providers.
Soehnholz: The contrarian view Dr. Dirk Soehnholz, Managing Director FERI Institutional Advisors, voiced a contrarian view, doubting if replicators can really outperform "good investable hedge fund indices". True to the saying "I've never seen a bad backtest", Soehnholz doubted the value of backtest series often presented by replicators. He also pointed out that once the replicator operates in real time, some of them reach a correlation of 0.8 to the MSCI World index, therefore highly questioning their diversification benefits and "downside protection". FERI sponsors an investable hedge fund index, which according to Soehnholz displays a lower volatility and even more attractive "after all fee" costs compared to available replicators.
"Suppliers of 130/30 and replication products have to show that they are not just hte next bad hedge fund with a limited investment universe and inexperienced management (130/30) or passive approaches to the complex world of hedge funds. In contrast, some investable hedge fund indices have already shown that they are attractive for more than five years and therefore also in difficult market conditions." In a side note, Soehnholz mentioned his firm has identified over 220 different factors which influence hedge fund returns, and the list keeps growing.
Beckers: Don't add another flawed investment option Stan Beckers, Head of Alpha Management Group, Barclays Global Investors goes even further. The root problem of all is that most hedge fund managers would not provide "true alpha", so why bother and create another plethora of flawed investment options.
Fung says it's really about "leaving the the people who can produce true alpha doing their job, but to "mechanise" the beta aspects of performance and drastically lower investment fees."
Harry Kat: Why replicate if you can create? Kat defines Hedge fund replication as "designing mechanical trading strategies in traditional assets that generate hedgefund-like returns." Further, hedge-fund like returns can be understood either as as a strict replication - the same returns month-to-month, whereas weak replication would mean same return properties. Kat's FundCreator approach is designed as a weak replication.
This can be done by either "creation" in a significantly different way than a hedge fund operates, or by "imitation" (acting similar to an hedge fund).
Most hedge fund replication attempts so far have been aimed at hedge fund index replication, and strict hedge fund replication has not been achieved so far, according to Kat.
Kat admits the alpha of synthetic funds comes from reduced costs, improved liquidity etc., not from superior investment skills. It would not be possible to replicate superior skills.
Kat mentioned in a side note that since his FundCreator went live some two years ago, some clients are not using the method to achieve returns but to change or optimize their risk/return profile. As the system is dynamic and diverse statistical properties can be defined as target parameters, it offers a hedge fund of fund or even single hedge fund a proven method to smoothen and optimize its own risk profile and volatility by adding a synthetic overlays.
Another interesting aspect of the system is that Kat says it is possible to replicate a certain hedge fund after having fed the FundCreator with its statistical properties, FundCreator will be possible to continue to trade even if the "underlying" hedge fund decides to either stop trading and goes cash or change the strategy when the (fundamental) opportunity set for the hedge fund (for example arbitrage) has vanished.
HEC replicates Kat! Dr. Nicolas Papageorgiou said the HEC University in Montreal has developed, together with Desjardins Global Asset Management, a synthetic futures trading model similar to Harry Kat's model. Papageorgiou believes that such an approach to create synthetic funds is highly feasible. No online Source
Here are a few more tidbits from the Hotel President Wilson here in Geneva…
“I’m thinking about launching an index fund of replicated hedge fund index funds!”
- John Godden, IGS Group, jokes about a fund of funds to replicate the replicators
“Alternative beta is like sex in high school. Everyone talks about it, but no one is actually doing it. Well we have had sex…and we don’t pay for it…In fact, sometimes we get paid!”
- Peter Norman, AP7 Pension Plan on his policy of investing in low-cost alternative beta and often generating revenue by lending equities.
“We call it Virgin Beta…It’s just a wording.”
- Mikael Simonsen, Ice Capital, on a new form of beta somewhere between alpha and alternative beta.
“I live for rare events.” “You simply can’t ignore extreme events. For example, if you remove 2 hours out of O.J. Simpson’s life, he’s a perfect citizen.” “Standard deviation is not a concept that is workable in finance.”
- Nassim Nicholas Taleb, risk expert and best-selling author on non-normal distributions
“We weren’t that enthused about it.”
- Neil Simons, Northwater Capital, on the correlation-targeting aspects of distributional replication
“Hedge fund replication will drive a normalization of hedge fund fees.”
- Gianluca Oderda, Pictet Asset Management on the impact of hedge fund replicas
Alpha Male has attended more hedge fund conferences than he cares to remember. Many of them have begun with several empty seats and ended with far more. But apparently the good citizens of Geneva know a hot financial topic when they see one. You know all those seats along the back wall for late comers? All packed. You know the aisle - where you walk - to get to your seat? Also packed (with extra chairs that had to be brought in). The main conference hall of the Hotel “President Wilson” in Geneva was overflowing yesterday morning as Professor Bill Fung of the London Business School kicked off this two-day gabfest on hedge fund replication. Thankfully, it appears the Geneva fire marshal must have been off having a chocolate eclair at some swanky cafe by the lake.
Why all the interest? Hedge fund replication - that esoteric and highly quantitative discipline that had struggled for attention only a year ago - has suddenly hit the mainstream.
But rather than freaking out about it, it seems that many hedge fund operators have embraced the old enemy and have positioned hedge fund clones as a complement, not a substitute, to traditional hedge funds. For example, Fung himself told the audience:
“Hedge fund replication is here to supplement existing hedge fund strategies by providing greater liquidity and transparency.”
As a result, many (actually most) of the speakers yesterday came armed with their own offerings. We found nothing inherently wrong with this. But it did make me long for the days when a small minority of speakers pitched their wares while the majority just wanted to share some cool research about the behavior of hedge funds. But I guess that’s what they mean by the “institutionalization” of the hedge fund business.
There was a lot of talk about hedge fund indexes, even though the event was not actually about that topic. In fact, speakers seemed to jump seamlessly between hedge fund replication models and hedge fund indexes - as if the two were synonymous.
And I guess they are synonymous to those who are in the replication business to produce alternatives to existing hedge fund indexes (e.g. JP Morgan). But to many (e.g. Fulcrum Asset Management), hedge fund replication is more than a tool to match the average hedge fund return - it’s a tool to produce alpha.
But for those who aimed to simply represent the average returns of hedge funds, the question then became: which index are you trying to clone? Several speakers pointed out that the difference between different hedge fund indexes could be as much 4% per annum. So a passive hedge fund replication technique with a high correlation to one of the hedge fund indexes might also have a relatively low correlation to another of the major hedge fund indexes.
Hedge Fung Replication
Fung believes that the reason hedge funds exhibit such a high correlation in times of distress (e.g. August, for some strategies) is not because they share the same assets, but because they share the same liabilities. In other words, Fung says “they all borrow from the same investment banks”.
Ergo, says Fung, any successful hedge fund replication model must integrate elements of the hedge fund industry’s liabilities, not just their assets.
Fung also presented several interesting slides showing the performance of the major hedge fund clones over the summer. We’ll try to wangle those from him tomorrow. But the bottom line is that after a pretty good first half, most lost a tiny bit in June, a bit more in July and even more in August (although they recovered from an average drawdown of several percent at mid-month).
“No Desire to Replicate the Downside”
Gavyn Davies, former head honcho at the BBC, Goldman Sachs banker, columnist for the Guardian newspaper and the founder of Fulcrum was one of the attendees that expressed no desire to fully replicate the average hedge fund. Taking a more active and liberal view of the term “replication”, Davies illustrated to the audience how his “risk stream” and “active trading” approach blew the pants off the traditional hedge fund indexes.
Davies also had some choice words for funds of funds. According to his research, it would take a fund of hedge funds about a 20% gross return to produce the same net return as a passive replication product with a 14% gross return (mainly due to the lower fees of most clones).
On the other hand, argued Davies, factor replication models “have trouble with market turning points” since they generally look back 24 months or more to calculate the appropriate factor weightings for the next month. Therefore, when the tech bubble blew up, (back-tested) factors models didn’t clue-in to the fact for over a year.
In contrast, he says, his “Fulcrum Alternative Beta Plus” (FAB-Plus) model reacted much quicker to such events and therefore had a much lower market correlation than many factor models.
Still, Davies echoed Fung when he told the audience that alternative beta funds and real funds of funds “will both have a big future”.
JP Morgan Stanley
The Fung & Hsieh-advised JP Morgan Alternative Beta Index (ABI) then went head to head against Morgan Stanley’s new “Altera” offering (Alt-era. Get it?). Both funds were given a performance-agnostic spin. JP Morgan’s Lakshmi Seshadri and Morgan Stanley’s Yazid Sharaiha both emphasized that their objective was to mimic the hedge fund universe, not to beat it. Sharaiha said his idea of a great hedge fund replication model was one that worked “out of sample” (i.e. one that actually explains hedge fund returns in different time periods). And Seshadri said that the “alpha-centric” industry needed an objective benchmark.
A Natural Extension
Philippe Schenk of Credit Suisse Tremont Index LLC rounded out the morning by proposing that “replication is a natural extension of the index business”. But he also asked why anyone would want to develop another product when most already produce much of the alternative beta embedded within investable hedge fund indexes.
In answering his own question, Schenk said that “now we can focus on trying to replicate the (better performing) non-investable hedge fund indexes.”
The Contrary View
Just when everyone - funds of funds and clones alike - were starting to get along, the afternoon speakers rocked the boat.
Dirk Sohnholz of FERI Institutional Advisors teed things up by accusing providers of hedge fund clones of cherry-picking the benchmarks that made their products look best (whether or not the clone’s objective was to beat or simply match the indexes). Reflecting a modest level of cynicism, Sohnholz told the audience that “marketing-wide, hedge fund replication is a great story.”
But if Sohnholz teed it up, BGI’s Stan Beckers hit the 400 yard drive - landing it right between the eyes of the hedge fund replicators gathered in front of him. In a blunt tirade that some in the audience actually admitted was refreshing in its candor, Beckers railed against any form of hedge fund replication and predicted the industry would all but disappear in 5 years. He saved his best barbs for the hedge fund indexes that replicators aimed to mimic, complaining that the industry was “targeting an illusionary, flawed and poor reflection of the hedge fund universe.”
Fung agreed and raised questions of his own about the accuracy of hedge fund indexes. However, the CISDM’s Hossein Kazemi (who ran such a database) said his research indicated that hedge fund indexes were actually pretty accurate reflections of the hedge fund universe after all. An audience member - I think it was Deutsche Bank’s Tony Chapple - told Beckers that the problem of the missing mega-funds was essentially solved by mimicking a fund of funds index since such an index would essentially reflect the performance of the world’s largest (non-reporting funds) via the funds of funds in their databases.
Flying Dutchman Fights Back
Harry Kat, the human lightning rod for strong opinions on this topic, then addressed the gathering and responded to “10 Unjustified Criticisms of FundCreator” (his distributional replication tool). We’ll leave the details for a future posting. But suffice to say, the panel had mixed feelings about Kat. At one end of the spectrum, Fung continued to attack things such as the model’s reliance on monthly data to make daily trades and the fact that an investor might have to wait 2 years or more to find out if FundCreator was actually working properly.
At the other end of the spectrum was Nicolas Papageorgiou of HEC Montreal Business School. Papageorgiou studied under Kat and along with his client, Canadian giant Desjardins Global Asset Management, he is a proponent of distributional replication (you may recall his paper on the topic).
In the middle were Kazemi and author Nassim Nicholas Taleb (speaking tomorrow) who both expressed reservations about distributional replication, but never really took a swipe at the Kat.
And that’s how things ended up on day one. With impassioned opinions, colourful debate and not an empty seat in the house.
Heard on the floor at Terrapinn’s “Hedge Fund Replication & Alternative Beta” conference in Geneva so far today…
“His trading process may be “naive”, but his fees sure aren’t!”
- Professor Harry Kat on the hedge fund replication strategy pursued by another well-known firm.
“The asset information submitted to any of the databases is absolutely useless. How many of the biggest hedge funds in the world actually provide an information to any database? BGI, one of the world’s largest hedge fund managers, does not submit its data to any of the hedge fund indexes.”
“Five years from now, all hedge fund replicators will be out of business. We’ll all look back and think ‘what a silly idea that was’!”
- Stan Beckers, Head of Alpha Management, BGI on hedge fund databases and hedge fund cloning in general
“Tom Schneeweis and I published our own hedge fund replication results on our website 6 years ago. But we only got 2 phone calls…No one cared…so eventually we stopped doing it. Apparently we should have continued.”
- Hossein Kazemi, Center for International Securities and Derivatives Markets (CISDM), jokes about his sense of timing in front of an overflow conference audience
A Beta Way To Boost HF Returns, From InsitutionalInvestor.com, 21/9/7
The secret ingredient to boosting performance of a hedge fund portfolio is some alternative beta, according to Stonebrook Capital Management. In fact, a first-of-its-kind study conducted for the New York-based firm that specializes in AB, says 30% is about the right mix. Based on 14 years of backtesting, the research found that the optimized portfolio containing AB generated annualized returns of 11.2% with a 3.53% standard deviation. In contrast, Hedge Fund Research’s HFRI Fund of Fund Index clocked in at 9.13% per year with a standard deviation of 5.56%. Says Jerome Abernathy, Stonebrook’s chief investment officer, who co-authored the study with Ahmad Ajakh, the firm’s director of research. “The study shows that alternative beta represents an important tool in the construction of hedge fund portfolios,” adding that AB “materially improves the liquidity characteristics of the portfolio, enables investors to concentrate on identifying and investing in high alpha managers and reduces headline risk.” Stonebrook says it has recently launched an AB product in a fund format, said to be the first of its kind in the U.S. “Alternative beta is quickly gaining acceptance as a liquid-efficient means to achieve the risk and return characteristic over the overall hedge fund industry,” notes Ajakh.
State Street Quietly Launches Hedge Fund Clone, HEDGEWORLD 18 September 2008
BOSTON (HedgeWorld.com)—State Street Global Advisors is the latest asset manager to launch a hedge fund replicator, following close on the heels of such firms as Goldman Sachs, Barclays and, most recently, Morgan Stanley. The new product has been running since July with seed capital from SSgA. The asset manager has to-date taken a low-profile approach in marketing the product to clients as it develops a track record.
The new clone uses a factor-based approach to identify the return drivers of various strategies. The objective is to "identify beta factors that have high explanatory characteristics with respect to HF returns," Paul Brakke, head of SSgA's global structured product group, told HedgeWorld on Tuesday [Sept. 18]. The approach is similar to that used in alternative beta products from Swiss asset manager Partners Group and AlphaSwiss, as well as to the Alternative Beta Index proposed by JP Morgan Previous HedgeWorld Story.
Not surprisingly, since SSgA's replicator has been developed, Bill Fung, David Hsieh and Narayan Naik have been working together on it. The three are among the best-known researchers into hedge fund returns and their drivers, and their research also underlies JP Morgan's Alternative Beta Index and replicator products based on it. Mr. Fung is currently visiting research professor of finance at the BNP Paribas Hedge Fund Centre at the London Business School, where Mr. Naik is professor of finance and director of the BNP center. Mr. Hsieh is Bank of America Professor of Finance in North Carolina's Duke University.
"Bill and I have been working on identifying the components of hedge fund returns for 10 years," said Mr. Hsieh in a conversation with HedgeWorld earlier this month. "Our model is factor-based in that we have tried to understand the core trading strategies in each hedge fund style and to reproduce them. The instruments that we use vary across the strategies." He said the main question the pair needed to address was: What instruments can reproduce returns that look like the ones they have observed?
"The general philosophy is that if you have a set of managers, you want to model what is common between them," said Mr. Fung. "You are trying to capture underlying common strategy." Replication is not about replicating the manager, he explained. "They change with market events and opportunities—their emphasis shifts over time in accordance with the markets, and it's difficult to follow single shifts in the way risk capital is being used."
In short, if managers stop doing what they do well, returns will suffer. "It is therefore a mistake to try to model manager by manager, since you expect them to change," he said.
With some strategies such as commodity trading advisers or managed futures, the pair observed, returns look similar to those on look-back options, in effect pairs of structured options, which Messrs. Fung, Hsieh and Naik have studied extensively.
"We're tracking general trends," Mr. Hsieh said. "By the time a typical manager reacts to a change, we have plenty of time to pick it up in model. We're tying to capture what managers are doing, we're not trying to predict what they're going to do. We tend to be reactive, so the model may be accused of being slow, but it is accurate."
But if the reaction of the model is slow, how does it protect itself from something like the blowup in many directional strategies seen in August when volatility suddenly spiked? After all, particularly in hedge fund land where there tend to be a large number of leveraged bets, the impact of adverse events on performance can be extremely quick, while the reallocation of assets is generally a lot slower.
"What got interesting [in early August] was that so called non-directional strategies began to demonstrate characteristics similar to an insurance-type of risk exposure, in line with the old adage that at bad times things tend to converge," said Mr. Fung. "With our model, in a very subtle way seemingly non-directional strategies do show up. They have extreme tail risk exposure to liquidity risk, which does show up in our model."
Mr. Brakke noted that look-back options also come into play in these circumstances. "Look-back straddles are used to pick up non-linearity obtained from hedge fund returns," he explained. "They provide investors with some degree of tail insurance."
Further, noted Mr. Hsieh, the risk management of the portfolio is guided by the decisions made by the individual investor, "so their asset allocation tells us where they want concentrated risks and where they don't." Mr. Fung added: "The long gamma positions achieved through look-back straddles help to ensure they don't get destroyed if extreme tail risks should materialize."
One thing the SSgA replicator won't be doing is looking to capture liquidity premiums. "It's hard to capture a liquidity premium when you're using liquid securities," said Mr. Fung. "Moreover, the cost of managing and executing this kind of position is much higher than for a more passive replicator, and ends up being just as expensive and opaque as a normal hedge fund."
"If someone could replicate the performance of illiquid securities, they'd have launched a product on the market by now," added Mr. Hsieh.
"Our model is slightly different from JP Morgan's Alternative Beta Index," Mr. Brakke explained. "The factors are pretty much the same, but the asset being used to replicate the factor can be different. If you want a particular type of yield curve exposure you will choose the most appropriate tools in accordance with the client's situation." While JP Morgan has constructed its index to best capture the returns of alternative beta, SSgA has taken a more dynamic approach by considering the client's existing portfolio and the cost-effectiveness associated with adopting a different strategy.
Mr. Brakke said the generic version of the product would probably cost clients about 60 basis points in fees, though costs would be higher for clients requiring a more customized solution.
T-Rex (Total Return Exposure) strategy to synthetically replicate synthetically HFR Index performance From Structured Products Online.com: 7 August 2007
SGAM AI’s new Ucits fund replicates hedge funds SGAM Alternative Investments (SGAM AI) has launched a Ucits-III compliant mutual fund using the concept of the T-Rex (Total Return Exposure) strategy, which replicates synthetically the performance of the Hedge Funds Research (HFR) Index. This is achieved with a managed portfolio of liquid financial instruments such as futures on the major assets, including equities, bonds and currencies.
The allocation process of the fund is based on a quantitative model, created by SGAM AI’s structured asset management team. The model calculates the allocation that offers a high correlation to the performance of more than 2000 hedge funds tracked in the HFR database without the subjective input of a fund manager. In order to maintain this high degree of correlation, positions are re-weighted every month.
The Ucits-III compliant fund offers daily liquidity and transparency as the portfolio allocation will be published continuously on the SGAM AI’s websites. Other than retail investors, the fund aims to attract asset managers and private banks that are looking for an underlying for structured products.
Morgan Stanley announces altera, an improved platform for alternative investment replication strategies From Opalesque, 26 July 2007
Morgan Stanley announced today the launch of altera, a new investment platform that will give investors access to ‘alternative beta’ strategies through mutual funds or customized contracts. altera will draw on the intellectual capital from many areas of the Firm. This product will give our clients access to Morgan Stanley’s best trading strategies across asset classes and allow them to benefit from the multiple sources of quantitative and derivative expertise we have available,” said Kevin Woodruff, Head of North America Equity Derivatives. Offering key innovations compared to first-generation hedge fund replication products, altera aims to achieve industry-leading performance. “Our objective is to match the performance of a leading benchmark hedge fund index,” said Yazid Sharaiha, Global Head of Quantitative and Derivative Strategies. “In backtests, the altera model achieves this performance objective while at the same time offering improved liquidity, controlled turnover and more transparency than an actual hedge fund.” Morgan Stanley’s altera improves upon first generation products by using tailor made, high performance investment strategies. Backtests demonstrated that altera’s choice of strategies improved hypothetical returns when compared to those used by existing products. Another altera innovation is an advanced quantitative methodology that both increases returns and reduces risk compared with existing products. According to Patrick McAllister, Head of North America Quantitative Equity Product Origination, “altera’s methodology is especially valuable around market turning points, offering the possibility of better results than first-generation products at these critical times.” Morgan Stanley plans ongoing research and continuous improvement in quantitative methods for altera. Another differentiating factor is altera’s use of MSCI’s Hedge Fund Indices as benchmarks. The MSCI Hedge Fund Indices facilitate detailed performance measurement and attribution due to their flexible design and use of MSCI's granular Classification Standard for categorizing hedge funds. Furthermore, Morgan Stanley plans to extend altera to cover selected single strategy indices in the future in addition to the composite.
Move to mimic hedge fund glory: From FT, June 18 2007, By Deborah Brewster in London
Why pay a 20 per cent performance fee for a hedge fund when you can replicate one for almost nothing? A slew of products using computer models to clone or replicate hedge fund returns are being launched in a bid to capture some of the billions of dollars flowing into the industry.
The products have the potential to revolutionise the industry, in much the same way as indexed funds affected mutual funds.
New York-based Stonebrook Capital is the latest to launch what it calls an “alternative beta” strategy, using models to replicate hedge fund strategies. It charges a 1.5 per cent management fee instead of the 2 per cent management fee and 20 per cent performance fee typical of actual hedge funds. The firm is also one of few African-American owned hedge fund groups, an advantage given pension fund pressure to allocate business to minority-owned firms.
Jerome Abernathy, the founder of Stonebrook, said research shows 70 per cent of gross hedge fund returns could be attributed to market returns rather than the skill of individual managers. Also, more than 30 per cent of gross returns went to the hedge fund manager in the form of fees.
Goldman Sachs, Lynch and Bank have launched hedge fund replica strategies, available to institutional investors. JPMorgan will launch one in the next few weeks, in a tie-up with three academics who produced the definitive research showing that hedge fund returns could be duplicated by computer models. IndexIQ, a New York-based quantitative strategist, has launched a series of synthetic indices which it is offering to distributors.
Rydex Investments, which services retail investors, was the first to launch such products. It has attracted $500m in the past 18 months to its three funds, which replicate hedge fund strategies but are structured in the form of mutual funds. It launched a replica managed futures fund two months ago, which has already pulled in $140m in retail money.
Patrick DiNuzzo, an investment adviser, said: “We have been dying for this type of solution for years... they are at the leading edge of enormous demand in the marketplace.”
Rydex plans several more replicas, based on merger arbitrage and currency strategies. The returns of its main fund so far have slightly underperformed most indices.
The products offer average hedge fund returns, not the outstanding returns that some individual managers do. However, the risk of a diversified portfolio is less. And they charge less than either a single fund or a fund of funds, the previous method of getting diverse hedge fund exposure.
Investable hedge fund indices, launched a few years ago, have not caught on because they do not include funds closed to new investors, cannot properly replicate the hedge fund industry, and tend to underperform. The synthetic indices and funds have no such hurdles because they do not include actual funds, but analyse typical strategies then recreate them.
Copyright The Financial Times Limited 2007
Deutsche Bank unveils low-fee hedge FoF `beta replication index`
From Finalternatives.com, May 25, 2007
Deutsche Bank has launched a new beta replication index that seeks to produce fund-of-hedge-fund-like returns without the high fees.
The db Absolute Return ßeta Index uses a proprietary algorithm to invest long and short across a variety of asset classes. According to Deutsche Bank, the product improves on existing investable replication indices by replicating returns before fees.
“It is a natural evolution of a maturing hedge fund industry that beta products will be introduced to complement active alpha managers,” global head of fund derivatives Stephane Farouze said. “I believe that the db Absolute Return ßeta Index is superior to the other hedge fund replication products due to its unique construction methodology in adding back to the hedge fund fee structure, and as a result its superior performance.”
Deutsche Bank said dbARß can be accessed via UCITS III Funds, certificates and notes in a number of different formats.
Merrill Lynch today introduced ML FX Clone, a methodology for replicating hedge funds' foreign exchange (FX)
strategies that will help investors to better understand and ultimately access the FX markets with greater ease and at lower cost. ML FX Clone is designed to replicate the most widely-used FX investment styles followed by active portfolio managers. Merrill Lynch research analysts have designed ML FX Clone for investors who wish to gain exposure to FX as an asset class or who wish to hedge underlying exposure to currency funds. ML FX Clone also helps investors to separate manager alpha - how much the portfolio manager contributes to returns - from beta - how much market factors contribute to returns. "Our replication strategies offer attractive returns and diversification benefits similar to those of broad currency portfolio manager indices," said Alex Patelis, head of global foreign exchange and local currency strategy at Merrill Lynch. "However they are more transparent, have greater liquidity, little manager risk, and have potentially lower trading and transaction costs."
Replicating Three Strategies: Momentum, Carry Trade and U.S. Dollar
ML FX Clone was developed to help make foreign exchange a more accessible asset class by providing more information and insight on the three investment strategies that FX portfolio managers most commonly use. The first strategy is momentum, in which a portfolio manager identifies and follows market trends. The second strategy is the carry trade technique, in which investors buy currencies from economies with higher interest rates and sell those from economies with lower interest rates. The third strategy is the U.S. dollar method, in which investors take a view on a currency relative to the value of the U.S. dollar. Merrill Lynch analysts have established a high correlation between the ML FX Clone model and existing benchmark currency market indices, including the Parker FX index. This indicates that the process can capture much of the variability in the returns achieved by different portfolio managers. Backtesting analysis shows that ML FX CLONE achieved an average annual return of 9.1% with a 0.82 Sharpe ratio -with only one year of negative returns since 1989 -, compared to 9.0% and 0.94, respectively, for the Parker FX index. Over the past three years, ML FX CLONE has mirrored the underperformance of the Parker FX index.
Merrill Lynch analysts noted in an October 2006 report, "Replicating Hedge Fund Returns, New Alternatives in Hedge Fund Investing," that as the hedge fund industry matures and more active managers share and compete for available returns, justifying paying higher fees for active management may be increasingly difficult if similar strategies can be mechanically implemented at lower cost.
Deutsche Bank unveils low-fee hedge FoF `beta replication index` From Finalternatives.com: Deutsche Bank has launched a new beta replication index that seeks to produce fund-of-hedge-fund-like returns without the high fees. The db Absolute Return ßeta Index uses a proprietary algorithm to invest long and short across a variety of asset classes. According to Deutsche Bank, the product improves on existing investable replication indices by replicating returns before fees. “It is a natural evolution of a maturing hedge fund industry that beta products will be introduced to complement active alpha managers,” global head of fund derivatives Stephane Farouze said. “I believe that the db Absolute Return ßeta Index is superior to the other hedge fund replication products due to its unique construction methodology in adding back to the hedge fund fee structure...
All about Alpha, 15 March 2007, Professor Harry Kat responds to EDHEC study on hedge fund replication
After yesterday’s story on EDHEC’s new hedge fund replication research, we were curious about Harry Kat’s take. With some cajoling by us, Professor Kat responds below…By: Prof. Harry Kat, Cass Business School, City University (London) In a recent interview published at All About Alpha and a research paper presented at the Edhec Asset Management Days in Geneva on March 13, Edhec researchers make some statements with respect to the workings of and results that can be obtained from our “FundCreator” technology that could be misconstrued. In this note I hope to clarify a few important issues. But first, I’d like to start with a short story that will clearly illustrate the point that I’d like to make. “Leo” and “Chris” are walking down the High Street and suddenly notice this beautiful shiny new car. They stop to take a closer look. “What is it?” says Leo.
“I don’t know”, says Chris. “…never seen anything like it”.
“Hey, wait a minute”, Leo shouts, “It says ‘Rolls Royce’ over here”.
“That must be it then.” says Chris. “It’s the latest Roller. I think I read something about it in a car magazine in the supermarket last week”. After taking another good look, both wander off fantasizing about what it would be like to have a car like that themselves. Closer to home, Leo suggests they build a Rolls Royce for themselves. Chris agrees and offers his tools and his garage as a workshop. The two go to work and by the evening their car is finished. Indeed, it looks very much like the real thing. They both jump in and hit the road. Driving around the neighbourhood, however, it quickly becomes evident that the car they built looks a lot better than it drives. It’s bumpy, takes 20 seconds from 0 to 60, doesn’t steer properly and the brakes squeak. Of course, that’s not really surprising, as they only got to see the outside of the Rolls they were trying to replicate. And Rolls Royce has been refining the inside of the car for nearly 100 years. Disappointed, Leo and Chris return home to evaluate their efforts. What are Leo and Chris to conclude? Will they conclude from today’s experience that Rolls Royce doesn’t make good cars? No. Ultimately, Leo and Chris draw the only rational conclusion: that their attempt to build their own Rolls Royce was unsuccessful.
Now turning our attention back to FundCreator and the Edhec research, one could tell a very similar story. FundCreator’s roots go back more than 7 years. Over that period, more than 10 man-years have been invested in developing the various procedures and the system itself. Packed with state-of-the-art estimation, optimisation and stochastic control routines, the FundCreator C++ code currently spans over 17,000 lines. Nobody can realistically expect to recreate this in the comfort of their own garage. Indeed, with the help of our November 2005 research paper one could build something that looks like FundCreator on the outside, but since it is difficult to surmise what really goes on inside the machine, one should not expect the same results. In other words, and in my view, EDHEC researchers simply did not accurately replicate FundCreator. Apart from not accurately replicating FundCreator, the Edhec researchers may have misinterpreted some of the published results. In the aforementioned interview, for example, EDHEC says, “Using the S&P 500 index as the reserve asset (as Kat does), our replications under-perform systematically and significantly, by approximately 500 bps per year.”
However, in FundCreator, the reserve asset is not simply the S&P 500 index. Since the reserve asset is at the core of every FundCreator strategy, it should contain as little uncompensated risk as possible. We therefore advise everybody using the system to use a well-diversified basket as the reserve asset, not just one single index. In our own research we use a portfolio of Eurodollar, 5-year and 10-year note, Russell 2000, S&P 500 and GSCI or crude oil futures. Apart from leaving a lot of diversifiable risk, using only the S&P 500 as the reserve asset will pull in the full 2000-2003 equity bear market. It is therefore not at all surprising that the Edhec study finds the strategy underperforms significantly - it is significantly under-diversified.
So how can one evaluate something of which one doesn’t know what is going on inside? I think that’s simple - try it out and examine the results themselves rather than the methodology. We have never held back information about the results achievable with FundCreator. On the contrary, we have published a whole variety of back tests, on the FundCreator website (and elsewhere) going back to 1995. In my view, these back tests show one thing very clearly: FundCreator is efficient and remarkably robust with respect to transaction costs, the rebalancing frequency, the choice of reserve asset, etc.
“The proof of the pudding is in the eating” Don Quixote once said, and he was 100% right.
Place Your Bets: Investible Indices vs. Replication Strategies
Albourne Village / Global Pensions, March 12
Pension fund demand for hedge fund indices is minimal and the advent of replicator funds could deal a death blow to them, some of the world’s largest consultants have claimed.But FTSE Group alternatives business unit head Gareth Parker insisted passive indices would play “a very big role” in the hedge fund market going forward.He claimed some of the consultants’ scepticism was due to “an educational issue”, and also questioned the threat replicator funds could pose to their market share. “How do they know what they are replicating?” he asked. “Hedge funds – especially the good ones – are very secretive about what they are doing, so a replication fund will only be able to find out what they were doing a month ago when they release a report, but obviously you are then way behind the market.“Some 20% of the institutional equity money in UK is entirely passively invested. I am convinced that as the hedge fund market matures, there will be a very big role for passive indexes.”Mercer Investment Consulting principal Robert Howie said demand for hedge fund indices had been low among the firm’s clients and added the firm had generally steered clients away from them.“Investible indices are touted as passive investments, but the underlying managers don’t discount their fees, and to me that is illogical and contradictory. The whole point of index tracking is that you get it really cheaply, and that is simply not the case with investible indices.”He added replication strategies would probably be the future of passive investment in hedge funds.Watson Wyatt senior consultant Chris Mansi agreed. “The indices also can’t seem to access a better quality collection of hedge funds. They are not the most attractive sort of capital for high quality hedge funds,” he said.Wilshire Associates VP Paul von Steenburg said although uptake of such indices had been slow, some were “pretty hard to beat” on a risk-adjusted basis.“Each index provider does it completely differently, so some might not be appropriate at all, but others have better construction methodology.
HEDGEWORLD 13 Feb 2007, Replicators Up Pressure on Manager Fees
LONDON (HedgeWorld.com)—Everyone agrees that alpha is like gold dust and perhaps even harder to find. That essential truth helps to underline why about 300 delegates from pension funds, investment banks and consultants, crowded into the Landmark Hotel in Marylebone Monday and Tuesday (Feb. 12, 13) to hear from the leading advocates of hedge fund replication and alternative beta at an event produced by IRC Conferences. Sweeping aside the different approaches to defining and finding alpha, an overall theme emerged and one not designed to put a smile on a hedge fund manager's face. Quite simply, the days of 2% management fees and 20% performance fees, could be numbered. Not for all managers, of course, but for the vast majority whose performance fails to justify those rewards.
Stan Beckers, head of the alpha management group, at Barclays Global Investors, summed up the matter. "There are very few managers, Renaissance excepted, who have been able to generate alpha for 15 years." He offered the additional observation that a fair separation in a fund where alpha predominates would be one-third of gains to the manager and two-thirds to the investor. "I think we are miles from that in the hedge fund industry," Mr. Beckers added.
His dismay, perhaps understandable from an executive of a preeminent index creator, was echoed by Daniela Klingebiel, principal investment officer of the World Bank pension fund. "In the past, (hedge fund managers) have all been able to sell their product [with the 2 and 20 fee structure]." She observed that over the coming five years alternative beta and replication products will increasingly have the effect of forcing managers prove themselves at lower fees.
The second day of the conference brought the focus to so-called synthetic hedge funds. Harry Kat, director of alternative investment research at the Cass School of Business, provided a bevy of evidence about the results of replication. His product, FundCreator, allows investors to mix a variety of indexes and futures contracts to achieve a designated return profile.
He presented data replicating three well-known but anonymous funds, including a fund of funds, a convertible arbitrager and a short seller. It showed that the volatility, skewness and correlation were comparable.
"The properties we created were very similar to the ones of those funds," Mr. Kat said. He underlined the point that it is the properties of synthetic funds that are the focus, not the exact timing of the returns. The FundCreator, he added, could match or beat around 80% of managers, while letting investors design funds that are optimal for existing portfolios. Not only are costs a fraction of traditional hedge funds, but liquidity, transparency and capacity are all greater, he argued.
"The conclusion from what I've shown you today is that 80% of managers don't have enough skill to justify 2 and 20, let alone 3 and 30," Mr. Kat said. He also urged investors to distinguish between pre-fee alpha and post-fee alpha, and argued that in around 80% of cases the former isn't great enough to generate the latter.
Mr. Kat, too, paid homage to Renaissance Technologies, noting that the firm's founder and president, Jim Simons, "is one of the 20% we can't match." He added: "I'm not saying there is not skill out there. The big question is can you find the managers and pick the 20% who are going to do it for you."
Daily News, USA, 13 Feb 2007, JP Morgan Debuts Replication Index
The hedge fund replication craze continues to spread among investment banks. JP Morgan announced today [Feb. 12] the launch of its Alternative Beta Index (ABI) at a conference in London dubbed Hedge Fund Replication and Alternative Beta. This is the latest in a series of recent announcements from other banks, including Goldman Sachs late last year and Merrill Lynch last week.
Merrill called its ABI the first true investable benchmark for the hedge fund industry. Its purpose is to enable the separation of alpha from beta following a rule-based methodology centered on the passive representation of the hedge fund industry's systematic risk exposures and using liquid market instruments.
"We're looking to analyze the different strategies behind hedge fund returns and then decompose the strategies into the key drivers," said Lakshmi Seshadri, vice president with JP Morgan's North American Pension Advisory Group, where the product was created.
In line with other replication indexes before it, the ABI is a response to hedge funds' lack of transparency and high fees that prevent some sophisticated pensions and institutional investors from investing further in hedge funds. But the specific approach of this index is to create a real benchmark based on the broadest possible use of databases, which would offer users full transparency, limited bias and the possibility to be used as a representative tool for the customization of risks and returns on a client-by-client basis. Replication indexes offer a cost-effective vehicle for accessing hedge fund returns that meets the fiduciary standards of pension fund investors and a broader investor base. "If you look at the size of the hedge fund industry - $1.3 trillion - it appears big, but it's not compared to the $20 trillion of mutual funds. If you really want the large institutional money to come in, you have to get a benchmark right," said Ms. Seshadri.
JP Morgan plans to offer the index with daily liquidity, offering investors several risk-controlled formats suitable for various investment goals.
The index should be the first in a third generation of products that began with regular hedge fund benchmarks, followed by a second generation of investable indexes. The well-reported performance gaps between regular and investable benchmarks are often caused by a series of biases, such as survivorship bias for instance. As a result, investable indexes tend to underperform their non- investable counterparts. JP Morgan hopes to reduce those differences with its new version.
The index differs from others in several ways, said Ms. Seshadri. First, JP Morgan has partnered with three academics that have led the research in the field of hedge fund replication tools: Bill Fung and Narayan Naik from the London Business School and David Hsieh from Duke University. "Being able to replicate the hedge fund industry is a complex task and it is crucial to have the best names on board to do this, especially as strategies and trends evolve going forward," said Ms. Seshadri.
JP Morgan with its new index is not trying to look for the best performance, unlike other index providers. "When you see a good return, how do you know this is not a leveraged return?" said Ms. Seshadri. "We're not doing an outperformance product that would be just another benchmark or fund of funds in disguise," she said. Another key difference is the use of multiple database vendors to create the index. The replication is based on a wide representation of the hedge fund and fund of funds industry. For instance, it includes momentum-type trades represented by CTAs, which are not always present in other benchmarks.
To follow up with the ever-changing hedge fund trends, JP Morgan also will have an index committee for the ABI index, which will include Messrs. Fung, Hsieh and Naik, known in the academic world under the FHN acronym.
ABI is expected to be the launching pad for similar products to come in the future as the bank will use it as an underlying for structured products, which are among the fastest growing financial offerings worldwide. For instance, the new index could be used in a wide variety of wrappers, including those used for the creation of principal-protected notes, a bank spokesman said.
(c) 2007 Daily News; White Plains. Provided by ProQuest Information and Learning. All rights Reserved.
All about Alpha 13 Feb 2007, Flying Dutchman Portends Doom for Hedge Fund Industry
The Flying Dutchman is a legendary ghost ship that is believed to be a sign of imminent doom for mariners. This fact is surely not lost on Dutchman Harry Kat, who today flew into London’s Landmark Hotel and launched a blistering attack on hedge funds at major hedge fund conference - questioning the industry’s very existence. Kat claims synthetic hedge funds solve several problems with the hedge fund industry including, in his words, “annoying managers”. So like the ship, is Professor Kat a harbinger of doom for the hedge fund industry? Or, is he yet another false prophet - one of many littering the hedge fund annals? As regular readers will recall, Kat aims to replicate hedge funds - not by matching their returns, but buy matching only the distribution of their returns (conveniently, it turns out the actual returns generated by these cloned distributions happen to be around the same as those of the hedge funds themselves). Here’s a quick analogy we find useful: Flip a coin 100 times, and when you’re done, have a look at the distribution. Normal with a mean of 50, right? Now imagine flipping another coin at the same time. Both distributions should be roughly the same. Both will have a mean of around 50 and be normally distributed. So you’d be indifferent between the two coins. But the coins still won’t produce the same results in lock-step with each other. In fact, they will produce different results around half the time. That’s the thinking behind Harry Kat’s hedge fund replication methodology. He doesn’t aim to literally replicate the monthly returns (i.e. in their exact same order). Instead he aims to replicate the return characteristics of hedge funds (their means, standard deviations, skewedness, kurtosis and even their near-zero correlations to various securities). Kat cites research from various big names that shows factors can only explain about 20% of the volatility of individual hedge funds and around 50% of the volatility of hedge fund indexes.But Kat says his methodology explains (or more accurately “replicates”) nearly 90% of the volatility of hedge funds by trading only 5 basic futures contracts in a highly complex option-like manner. His software tool, “Fund Creator” constructs an exotic option by dynamically trading these futures contracts in a manner that yields the desired distribution characteristics. He saves his best barbs for hedge fund indexes which, he says, simply compound the problems with high hedge fund fees. He replicates the HFR and EDHEC hedge fund indexes and finds that, in several cases, Fundcreator actually produced a higher return. When asked about why his replicated means so closely approximate the actual means of his target distributions, he responds that “the hedge fund managers generate returns that are simply commensurate with the risks they take”. In other words, most hedge funds don’t produce alpha according to Kat. So beating them isn’t that hard. The ensuing panel discussion revealed some disagreement with the audience of hedge fund managers and with fellow panelists who immediately commenced a game of “gotcha”. Kat wasn’t phased though and deflected most shots without missing a beat. An academic whose first career in the investment banking business made him independently wealthy, Kat is obviously not in this for the money. And that’s what makes him so dangerous to his competitors (hedge funds and investment banks). He seems to be motivated primarily by a desire to challenge the status quo. In a sense, he is a ”non-economic player” in the asset management industry itself. With evangelical zeal and his trademark bluster, Kat concluded his session by saying: “Twenty percent of hedge fund managers can produce alpha after fees. But you can’t tell which 20% it is. They all look the same…the same Armani suits, the same Rolexes and the same Bentleys.” The Armani-clad, Rolex-wearing, Bentley-driving attendees in the audience weren’t sure whether Kat was playing a huge joke on them, or if this was the beginning of the end of the hedge fund industry as we know it. And that was rather unsettling for all.
All about Alpha 13 Feb 2007; Merrill Lynch’s Hedge Fund Replication to Go Mass Market
Ben Bowler and Steven Umlauf of Merrill Lynch weren’t going to let JPMorgan’s Lakshmi Seshadri steal the show with her hedge fund replication offering yesterday. Umlauf’s Merrill Lynch Factor Index (MLFI) also aims to provide a mechanical replication of hedge fund returns (using a 24 month rolling regression). One intriguing application that Bowler mentioned this morning was a tool to short-out hedge fund beta from a hedge fund manager’s performance in order to create an (alternative-)beta-neutral portfolio. Steven Umlauf revealed that the MLFI is designed to be straightforward and transparent (and “can be executed on a spreadsheet”) because the firm plans to mass market it. And as a structured product, the mass market will also be able to buy it. So we wonder if this will be the entrée into hedge funds for millions of small investors, regardless of the SEC’s final ruling on eligibility.
All about Alpha 13 Feb 2007; Jaeger: Hedge Funds Usher in “Atomic” Age of Investing
You don’t need a Ph.D. in physics to understand hedge fund replication. But Lars Jaeger has one just in case. And he used it masterfully today to draw an analogy between the model of the atom in the 19th century (a random mass of various particles) and the common paradigm understood today including a nucleus (containing most of the atom’s mass) and a number of electrons orbiting it. Until now, he argues, hedge funds have been viewed as a random mass of alpha, beta and error terms. But a new paradigm is now emerging that aggregates betas into a “nucleus” orbited by various alphas. The same could be said for active long-only investing in our view. Until now, long-only management has also been a mass of alpha and a set of betas (dominated by market beta). Jaeger’s Partners Group has developed replication portfolios to mimic the performance of various hedge fund strategies. The returns of these replication portfolios actually beat all hedge fund strategies except distressed (which, according to Jaeger, contains a lot of alpha and is therefore difficult to replicate). Jaeger says that long/short managers, on the other hand, are particularly susceptible to replication. Jaeger’s research shows that the correlation between hedge funds and their underlying factors differs depending on the fund’s volatility. For example, there could be one correlation value when the market is down and another correlation when the market is up. Emphasizing the link between hedge fund returns and market volatility, Jaeger says it’s no surprise that hedge fund returns have fallen in the past 5 years since global risk premia have also fallen. But later in his presentation, he also showed that alpha itself has fallen over this period. While this double whammy doesn’t bode well for hedge fund investing, Jaeger holds out hope in the form of hedge fund replication. Even if it turned out that most hedge fund returns were all beta, he suggests, there is still a compelling case to be made for investing in disparate alternative betas based on diversification grounds alone. In addition, he points out, investors would save on fees by investing in alternative betas (vs. regular hedge funds). Obviously, investors would pay lower management fees. But they also wouldn’t have to sell an under priced option to the manager in the form of an asymmetrical performance fee. Furthermore, investors wouldn’t have to pay the “fee” arising from the drag caused by un-invested cash kept as collateral by most hedge fund strategies. Jaeger’s firm manages an $850 million fund he describes as “not just the only, but the largest” hedge fund replication program in the world. It aims to replicate 18 hedge fund strategies and focuses on tactical asset allocation among these strategies. Jaeger concluded his presentation by once again drawing on his background in theoretical physics. Hedge funds, he says, are complex “molecules”. And hedge fund factors can be viewed as the atoms contained within these molecules. Using Jaeger’s analogy, it seems that we have indeed ushered in a new “atomic age” in asset management.
The worlds of filmmaking, fashion and finance converge on London this week. Dame Helen Mirren was crowned queen of the world at last night’s BAFTA awards (Britain’s Oscars), London Fashion Week has flooded this city with (highly controversial) size-zero models, and Professor Bill Fung presides over IRC’s “Hedge Fund Replication and Alternative Beta” conference today. Only able to attend one of these three events, Alpha Male eschewed the movie stars and super models and chose instead to spend the week with hedge fund stars such as Fung, David Hsieh, and Lars Jaeger. And while there were no catwalks or super models, we did enjoy plenty of super factor models.
While this event is ostensibly about hedge fund replication, it really speaks to alpha-centric in all its forms. Fung, who coined the term “alternative beta” in a chapter of a 2003 book edited by Lars Jaeger, kicked off the day by asking the audience, “Why pay 2 and 20 fees for what you can do yourself?” Whether it is possible to “do it yourself” remains to be seen. But regardless, this is the central question in alpha-centric investing today.
Fung’s research corroborates what the industry has sensed for some time now: that investable hedge fund indexes under perform their non-investable peers. Even when adjusted for management fees, the investable CSFB, HFRI and MSCI still under performed the non-investable versions of these funds (see recent post on one manager who royally panned these investable products). Fung proposes another method of capturing alternative betas that might not succumb to the “certain balls and chains” that seem to stymie the existing investable indexes. The manacles to which Fung refers include: high fees, opacity, illiquidity, and hedge fund risk
One of the first studies to explore hedge fund “cloning” was written by Mitchell & Pulvino (Journal of Finance, 2001). They showed that merger arbitrage could be approximated by a combination of long positions and put options. Fung’s own research shows a remarkable high correlation between one particular long-only mutual fund in the United States (called “The Merger Fund”) and the HFR Merger Arbitrage Index. He shows the same correlation between emerging market hedge funds and the IFC Emerging Market Index. Finally, Fung’s research shows CTAs are highly correlated with 10 year treasury volatility (i.e. they go up when the 10 year is either up significantly or down significantly).
Fung makes the point that replicating “the average” hedge fund leads to lackluster results since it ignores the sub-segments of funds “most worth looking at” and captures funds that are so bad, they eventually fall victim to poor performance. But on the other hand, he says, actively picking the sub-segments in a replication strategy is tantamount to managing an active fund of funds – the very products hedge fund replication aims to replace.
Fung made another interesting observation. He asks, “If someone could perfectly replicate the returns of the best hedge funds or strategies, then why would they
