Institutional Investor's Alpha Magazine - March 2009 - (Page 54) Hedge Fund Replication not want to pay alpha-type fees for beta-derived returns.” Powell is quick to cite academic research that supports the view that most hedge fund returns come from beta or from “systematic alpha” — rules-based trading strategies that can be replicated in a process otherwise known as hedge fund cloning. Even when hedge funds yield alpha, he argues, their fees usually end up swallowing it. Last March, USS acted on these convictions by announcing a $200 million commitment to State Street Global Advisors’ fledgling hedge fund replication product, Premia. SSgA, the $1.7 trillion investment management wing of Boston-based State Street Corp., launched Premia in July 2007. Along with a host of other replication offerings to hit the market during the past few years, Premia — like most clones — purports to offer hedgefund-like returns with lower fees and less risk. The USS-SSgA deal was the second such venture for USS, which has $44.6 billion in assets. In 2007 the pension giant put $200 million in a hedge fund clone run by Zug, Switzerland–based alternative asset manager Partners Group. But USS isn’t abandoning traditional hedge funds. Powell says the pension scheme is developing an integrated approach that combines replication strategies and single-manager funds. Out with the two and 20, then, and in with morereasonable charges? Maybe, but hedge fund clones are still a mostly nascent and untried sector. Total assets aren’t known, but the number is tiny compared with the $1.5 trillion hedge fund industry. Hedge fund replication, in fact, may emerge as a serious threat to the very vehicles it seeks to re-create. By doing away with alpha fees for beta results, clones are positioned to revolutionize the hedge fund industry in the same way that index funds transformed the longonly equity business, allowing more-affordable access to the same underlying assets. But for that to happen, managers of hedge fund clones may first have to finetune their methods, which don’t always allow for swift adjustments to changing market conditions. This is simply because replication models are based largely on the past rather than what may be happening in the present (meltdowns, rallies, currency and credit crises). Critics note too that replication comes more from academic than real-world experience. Although the name suggests otherwise, hedge fund replication isn’t about photocopying individual hedge funds. That would be almost impossible because hedge fund managers are so secretive and idiosyncratic. Many clones strive, in fact, to be average by using mathematical models to mimic the return profile of a benchmark hedge fund index like the HFRI funds of funds composite index, compiled by Chicago-based Hedge Fund Research. Others try to copy a particular hedge fund strategy — longshort equity or merger arbitrage, for instance. Either way, investors get hedge-fund-like exposure while avoiding single-manager risk. And last year there were much worse places in which to invest than hedge funds, whose decline was about half that of the broad market. After finishing 2007 up 9.7 percent, the HFRI composite index was down 18.7 percent in 2008. But the Standard & Poor’s 500 index plunged 37 percent. On both sides of the Atlantic, investors in search of clones have lots of choices. Credit Suisse, Deutsche Bank, Goldman, Sachs & Co., JPMorgan Chase & Co., Merrill Lynch & Co. and Morgan Stanley all offer replication products. Other players — in addition to Partners Group and State Street — include Cambridge, Massachusetts– based AlphaSimplex Group, Helsinki-based BlueWhite Alternative Investments and Greenwich, Connecticut –based AQR Capital Management, which recently launched a fund it bills as an improvement over earlier replication strategies. Still, hedge fund clones remain a niche product. In early 2008 the Nice, France–based Edhec Risk and Asset Management Research Centre surveyed asset managers, institutional investors, private bankers, family offices and finance professionals about hedge fund replication. Just 15 percent of respondents said they used replication products; 30 percent said they would never do so. Andrew Lo, the Harris & Harris Group professor of finance at the MIT Sloan School of Management and a pioneer in replication (see “Attack of the Clones,” June 2006), says he doesn’t expect resistance to persist, however, and that the replication trend is poised for exponential growth. Lo, who is also chief scientific officer and chair- “There should be demand for replication strategies. Why pay two and 20 if you’re not getting alpha?” — DEEPAK GURNANI, INVESTCORP As devastating as 2008 was, it may have thrown open the door for replication because, even if hedge funds are having a tough time generating alpha, the beta they provide is still a valuable commodity. Proponents say clones can deliver it more cheaply and with greater liquidity than can hedge funds (notorious for limiting withdrawals). And some people see clones as a way to offer mom-andpop investors a back door into hedge fund strategies. “We think hedge fund replication is, in a sense, the democratization of hedge fund investing,” says Anthony Davidow, a senior vice president and head of distribution at IndexIQ, a Rye Brook, New York–based firm that sells a replication mutual fund. “The reason it makes a lot of sense for the retail client is, it gives them access they haven’t had historically.” 54 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2009
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