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Alternative Investments - October 11, 2007

Hedge fund clones: key issues in distinguishing between them

by Walter Géhin, Research Associate with the EDHEC Risk and Asset Management Research Centre, and Business Analyst with Atos Euronext Market Solutions

While the ability to replicate hedge funds is still being widely debated, the last few months have seen one hedge fund clone launch after another (see Table 1). Partners Group, which is considered the pioneer in this area, launched its Alternative Beta Strategies at the end of 2004. Partners were followed by Rydex Investments and AlphaSwiss in 2005, and Merrill Lynch and Goldman Sachs in 2006. In September 2007, more than 20 hedge fund replicators were on the market. Some institutions have launched several clones, for example HedgeIQ with four clones, and Merrill Lynch with three.


Table 1


The main arguments that are presented at each launch are basically the same, i.e. lower costs than individual funds or funds of funds, easier access to the hedge fund universe by lowering the minimum investment level, or better liquidity. On the other hand, each new replicator is presented with the claim that the methodology is definitively different and innovative compared to the competitors. The increasing numbers of these clones introduces a new challenge that has replaced fund picking, namely clone picking. Behind the marketing arguments, it is indispensable for investors to understand what these products really are, and how to differentiate between them. In our opinion, two main characteristics enable hedge fund clones to be distinguished: the method used and the replication target.

Replication methodology

Concerning the replication method, three methods are available, i.e, the factor-based approach, the rules-based approach, and the payoff distribution approach. The factor-based approach is related to the increasing acceptance of the concept of alternative betas and the drift from an alpha-centric view to a beta-centric view have led several academics to try to replicate hedge fund performance by passively reproducing hedge fund exposures. In other words, this kind of replication consists in taking long and/or short positions in a set of factors that best explain the performance of a fund or an index in the in-sample period, and passively holding them in the out-of-sample period. Fung, Hsieh and Naik are the academics that have given the most extensive support to this method. They have teamed up with JP Morgan, State Street Global Advisors, and BlueWhite Alternative Investments. This kind of partnership undoubtedly adds to the credibility of the replication tools and is exploited as a marketing argument.

However, the lack of reactivity of this method has been highlighted, because it would have a negative impact on the accuracy of the replication. Hedge fund exposures are dynamic because managers adapt them according to the market environment. These dynamic exposures require rebalancings in the clone that cannot be carried out without a certain time of reaction. David A. Hsieh replies1 to this criticism by arguing that in SSgA’s clone, “we’re tracking general trends”, and “by the time a typical manager reacts to a change, we have plenty of time to pick it up in model”. The model‘s reaction time lag is crucial.

Partners Group’s Lars Jaeger considers that the factor replication approach adjusts “to changes in hedge fund exposures with a significant time lag with respect to the investment exposure of hedge funds.” That is why the Partners Group Alternative Beta programme introduces derivatives and conditional trading rules to replicate hedge funds’ non-linear behaviour. This method comes under the rules-based approach. It is important to stress that Partners Group use a combination of the factor-based approach and the rules-based approach. Morgan Stanley uses the same combination of both methods in its Altera product. Other clones go further; they only use the rules-based approach. This is the case for Merrill Lynch with its Equity Volatility Arbitrage Index and its FX Clone.

Nevertheless, by using short selling, derivatives, and leverage (in other words, techniques widely employed by hedge fund managers), the frontier between clones and actual funds is fuzzy. Heiko Ebens, who participated in the development of Merrill Lynch’s Equity Volatility Arbitrage Index, acknowledges2 that the programme executes “similar strategies that hedge funds employ” by shorting the S&P 500 stock index’s implied volatility. Here cloning does not mean replication of the returns of a fund or an index, but rather replication of a strategy to exploit the same risk premiums. It is the manner in which the funds are managed rather than their results that is reproduced. One argument sustaining this method is that rules are mechanically and systematically applied. While this type of systematic trading strategy cannot be considered entirely active, the label “semi-active funds” is certainly more appropriate than passive clones.

The payoff distribution replication approach was developed by Amin and Kat (2003). In more recent papers3, Kat and Palaro have transposed the methodology to hedge fund return replication, under the “FundCreator” label. Several critical opinions of this method have been formulated4. In a recent paper5, Kat and Palaro reply to these critics (more exactly to 10 critics). One of the main reproaches is that it does not match the returns of the target fund or index on a month-to-month basis. Kat and Palaro (2007) argue that, “at no point have we ever claimed that matching returns on a month-to-month basis is what we are after,” and that “the returns generated by FundCreator will have the same properties, but they will typically arrive in a completely different order than the target returns. For most investors this does not present a problem.” Another significant criticism is that investors have to wait several years to obtain accurate replication. Kat and Palaro reply that “since the publication of our 2005 paper, we have introduced an impressive range of (proprietary) improvements to our system.” Two years after their first papers, Kat and Palaro have not yet been supported by a financial institution to launch a clone based on their method. However, Harry Kat has informed us that the FundCreator method is currently in use in 3 institutions6. Here the goal is not the replication of a fund or an index, but the creation of “funds with tailor-made properties to further diversify investor’s existing portfolios without the hassle that comes with real alternative investments”. Kat adds that “the hedge fund replication hype has been helpful launching FundCreator, but we are now gradually cutting the link, as we don’t want to be seen as hedge fund replicators.” In summary, today the FundCreator creator is more prone to promoting its method as a fund design tool rather than a replication tool. Papageorgiou, Remillard, and Hocquard7 (2007) propose a modified version of Kat and and Palaro’s method, arguing that it corrects some of the shortcomings. Papageorgiou has teamed up with Desjardins Global Asset Management to develop a clone that will be launched soon on the basis of their academic work.

Replication target

At an IRC conference in February 2007, Harry Kat8 remarked that “factor models can only replicate very well diversified indices, which don’t make very interesting investments”. He gave the example of the Merrill Lynch Factor Index. According to Merrill Lynch, the correlation with the HFRI Fund Weighted Composite Index is 95%. Kat underlines that this index follows “all kinds of strategies” (more specifically, 37 sub-strategies). He argues that “the result is an index with mainly traditional risk exposures and very little is ‘alternative’ about it. This is exactly why this index can be accurately replicated.” The traditional exposures of the replicated index are not attractive because they do not give access to one of the main advantages of hedge funds, namely risk diversification.

From this angle, it is striking to observe that all the factor-based clones target a composite index or composite returns: the HFRI Fund Weighted Composite Index for the Merrill Lynch Factor Index and SGAM’s T-Rex, the HFRI Fund of Funds Composite Index for the JP Morgan Alternative Beta Index, SSgA’s Hedge Fund Beta Strategy and Stonebrook’s Alternative Beta Fund, and the aggregate position of thousands of hedge funds for the Goldman Sachs Absolute Return Tracker.

Some rules-based clones have composite targets: Deutsche Bank’s db Absolute Return Beta Index, AlphaSwiss’s Alternative Beta Fund, the HedgeIQ Composite, Rydex’s Absolute Return Strategies fund. But others focus on a particular strategy. For example, in addition to its Composite clone, HedgeIQ proposes three clones focusing on specific strategies, namely long/short equity, market neutral, and fixed-income arbitrage.

Conclusion

The wide range of hedge fund clones that is now available hides the current reality: the offerings have a considerable way to go to reach maturity. None of the three methods used to replicate hedge fund returns is backed up by academic consensus and they present shortcomings that should not be neglected by investors. In addition, a large number of clones target composite returns. Unfortunately, such clones do not have the diversification properties of specific strategies. Moreover, the replicated returns are at best an average return, where the returns of the best funds are mitigated by funds that perform worse.

In spite of these warnings, the marketing efforts by leading institutions will undoubtedly convince increasing numbers of investors and ensure the success of clones in terms of collective investments. It remains to be seen whether, in real life, clones will succeed in providing investors with the returns they are waiting for.



References

  1. M. de SaPinto, “State Street Quietly Launches Hedge Fund Clone”, HedgeWorld, September 2007.
  2. www.hedgeworld.com, “Merrill unveils new hedge fund replication index”, 02/07/2007.
  3. For example: Kat, H. M., and H. P. Palaro, 2005, “Who Needs Hedge Funds? A Copula-Based Approach to Hedge Fund Return Replication“, Working Paper, Alternative Investment Research Centre, Cass Business School.
  4. See Amenc, N., W. Géhin, L. Martellini, and J.C. Meyfredi, 2007, “The Myths and Limits of Passive Hedge Fund Replication, An Attractive Concept … that still is Work-in-Progress”, EDHEC Risk and Asset Management Research Centre., and Northwater Capital Management Inc., 2007, “Northwater Capital Management’s Thoughts on Hedge Fund Replication”, and Conquest Capital Group, 2007, “Hedge Fund Replication”.
  5. Kat, H. M., and H. P. Palaro, 2007, “FundCreator, Reply to the Critics”, Working Paper, Alternative Investment Research Centre, Cass Business School, September.
  6. According to Harry Kat, “a number of FundCreator-based products for private and institutional investors are about to be launched.”
  7. Hocquard A., N. Papageorgiou, and B. Remillard, 2007, “Replicating the properties of hedge fund returns“, Working Paper, HEC Montréal, July.
  8. www.allaboutalpha.com, Kat, H.M., “Why Accurately Replicated Hedge Fund Indices Won’t Do You Much Good”, 03/03/2007