The third way
IN THE PAST year, several investment banks have launched products that purport to give investors hedge fund-type performance without the need to actually invest in hedge funds themselves. Known variously as hedge fund replication strategies, hedge fund clones or alternative beta products, the strategies offer what sounds like the ideal alternative investment.
By simply buying a structured note from an investment bank, investors can, so the marketing goes, get exposure to the risks and rewards of hedge fund investing while avoiding the usual negatives of high fees, a lack of transparency, lock-in periods and capacity constraints. Merrill Lynch and Goldman Sachs opened the field last year with the launch of the Merrill Lynch Factor Model and the Goldman Sachs Absolute Return Tracker Index. Then, in May this year, Deutsche Bank launched its Absolute Return Beta Index. JPMorgan has announced that it intends to launch its own alternative beta index. Some fund managers have started to offer the strategy in fund format.
"Our approach is to offer full transparency, daily liquidity and low cost," says Darren Fortunato, director in the financial products group at Merrill Lynch in New York.
The banks hope that the ceaseless demand from investors for alternative exposures, despite this summer’s hedge fund blow-ups, will lead to large flows of money into their strategies. Meanwhile, by offering the exposure in structured note format, the banks can create a menu of risk and reward pay-offs, from principal-protected to leveraged structures. On paper it sounds like a great idea, but not everyone is enthusiastic about what the banks are doing. Indeed, doubts about the fundamental viability of the models the banks are using have emerged, with academic researchers doubting their propensity to generate hedge fund-like returns in the first place.
"The science is not there yet. It’s too early to say that this can be done," says Lionel Martellini, scientific director of the Edhec Risk and Asset Management Research Centre in Nice, France.
The starting point for the replication models is a body of academic and theoretical work built up over the past 10 to 15 years on hedge fund performance measurement, and specifically on splitting hedge fund returns into their component alpha and beta parts. This, in turn, has led to attempts to replicate the risk and return characteristics of hedge funds by putting in place automatic, passive trading strategies in regular, liquid financial markets, such as the equity, futures and credit markets. Edhec’s academics have examined the techniques that underpin the current batch of replication strategies, and Martellini says they have been found wanting. "It just doesn’t work," he says, adding that whatever returns the replication strategies are producing, it is certainly not hedge fund returns.
Models
The models used for hedge fund replication can generally be split into two camps, which academics and practitioners refer to as factor-based replication and payoff distribution replication – although a third method has also emerged (see The third way). The former is the method typically used by banks.
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"Factor-based replication is by far the most popular hedge fund replication strategy"
Jerome Abernathy, Stonebrook Capital Management |
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New York-based investment firm Stonebrook Capital Management launched its version of a hedge fund replication product this summer – the Alternative Beta Fund – using a factor-based model. It hopes to launch a structured note version of the strategy next year through its Stonebrook Structured Products subsidiary. "Factor-based replication is by far the most popular hedge fund replication strategy," says Jerome Abernathy, the firm’s chief investment officer, adding that a couple of trends have come together to give issuers the confidence to start selling replication products. "The research has matured enough such that a couple of years ago we all realized that this could be done. Also, the instruments that we use to model the underlying exposures are now readily available, either as over-the-counter instruments or exchange-traded funds," he says.
Factor-based strategists start by analysing historical performance data on a basket of hedge funds. This is most easily done by taking the performance data of a well-known hedge fund index, such as the HFRI Weighted Composite Index, which is designed to track the average performance of 2,000 hedge funds, or the Credit Suisse/Tremont Hedge Fund Index, which tracks more than 4,500 funds. Two, three or more years-worth of data is gathered. The modeller then seeks to replicate that past performance by putting together a portfolio of positions using only liquid investment instruments, such as exchange-traded funds. A position, which is also called a factor, could for example be a short position on the S&P 500 or a long bond investment. The challenge is to work out which combination of factors, in which proportions, would have roughly replicated the hedge fund index’s performance during the sample period. That portfolio is then constructed and run on a passive basis, with positions altered slightly each month as new performance data on the index come in.
Stonebrook, for example, tries to replicate the average performance of the HFRI over the past two years with a portfolio of indices comprising the S&P 500, the Russell 2000, the Eurostoxx 50, the MSCI Emerging Markets index, a Treasury notes index, a Treasury bond index and a US dollar index. Merrill Lynch, which also seeks to replicate the HFRI composite index, uses a combination of the S&P 500, the MSCI EAFE, the MSCI Emerging Markets, the Russell 2000, one-month Libor and US dollar exposure.
Abernathy says that, gross of fees, his strategy can "explain" 75% of the hedge fund index’s returns. "You get comparable returns to the hedge fund index but we only charge a flat 1.5% annual fee, and we offer weekly liquidity," he says.
Alpha beta
In order to justify their high fees, hedge funds like to present themselves as big alpha generators. The emergence of hedge fund replication, however, calls into question their self-appointed role as the kings of absolute return, suggesting instead that hedge funds are, for the most part at least, actually harnessing some form of beta. This ties in with the academic research on hedge fund replication, which suggests that hedge funds are mainly harnessing forms of "alternative beta" for clients rather than alpha. Edhec, for instance, looked in detail at how different hedge fund strategies generate returns and concluded that only about 4% of hedge fund performance can be attributed to pure alpha. Instead, the academics suggest that hedge funds actually specialize in giving investors access to alternative types of market risk, such as volatility risk, default risk and liquidity risk. Whereas a regular mutual fund acts as a type of intermediary to give investors access to the market returns of equity markets, hedge funds are merely intermediaries for giving investors exposure to other types of usually inaccessible market risks, say the academics.