Institutional Investor's Alpha Magazine - March 2009 - (Page 56) AQR’s Adam Berger sees replication as a way for small investors to have a crack at hedge-fund-style strategies. mon as it used to be. (Their paper, “Hedge Funds: Performance, Risk and Capital Formation,” published in the August 2008 edition of the Journal of Finance, offers support for their position.) Premia draws on research by Fung, Hsieh and Naik that shows that several “factor exposures” explain the bulk of the return variation of most hedge fund indexes, the standard industry benchmark. To obtain the right weightings of these exposures — two equity-related, two interest rate ones and three connected to options — Premia, Hsieh says, “regresses” them against historical data (it’s similar to the linear regression analysis that Nobel Prize– winning economist William Sharpe applied to mutual funds in the early 1990s, using historical returns data to study the relationship between well-known risk factors). Premia then gains exposure to hedge fund beta by building a portfolio using liquid instruments like futures, option contracts and swaps. SSgA vice president Bailey Bishop Jr., a senior portfolio manager in the firm’s global structured products group, says queries about Premia have poured in from Asia, Europe and the U.S. and that American foundations and endowments are interested in using it to reach their hedge fund allocation targets while they hold off on investing in single managers or funds of hedge funds. “They also see potential use for a strategy like this as a permanent allocation to one’s overall hedge fund exposure,” he notes. Including the March commitment from USS, Pre- mia had about $400 million in assets as of December 31. Bishop won’t discuss performance or fees, except to say that fees are significantly lower than the hedge fund standard. Replicators typically charge a management fee of 0.75 to 1.5 percent and do not charge for performance. Like its rivals, Premia relies on hedge fund databases to feed its statistical models, and Bishop concedes that a backward-looking method is not ideal. But, he says, managers consider other factors too. “These models are not static,” he explains. Drawing a parallel with indexed equity products, Bishop says SSgA has been gauging client interest in a “coresatellite” approach to building hedge fund portfolios. The result would be a foundation of core market returns through replication strategies, combined with returns from a select group of actual hedge funds (the satellites). And like indexed equity funds, clones offer institutional investors virtually unlimited capacity — in contrast with a traditional hedge fund, which might not be able to handle a big allocation from a state pension plan. Merrill Lynch, recently absorbed by Bank of America, has rolled out a clone similar to Premia. The Merrill Lynch factor model — one of several replicators offered by the New York–based firm — aims to track the HFRI composite index. It does so by investing in six popular and highly liquid indexes, including the Russell 2000, the S&P 500 and the U.S. dollar index. Yonathan Epelbaum, managing director for equity derivatives at Merrill, says the underlying model performs a simple linear regression on the past two years of hedge fund data: “It’s a formula we run every month, and the formula puts out numbers, and those numbers get used.” The Merrill replicator, which launched in June 2006, has attracted institutional and retail customers in the U.S. and abroad. It was down 13.8 percent in 2008, “doing as the hedge fund community has been doing,” Epelbaum says. Even if clones are performing as advertised, investors may still need some persuading. In last year’s Edhec survey, most respondents agreed that the main benefits of replication are liquidity and comparatively low fees. But almost half said they remained wary of hedge fund clones. Edhec Graduate School of Business finance professor Lionel Martellini has similar misgivings after tracking the performance of many replication products. “Overall, it looks a little bit disappointing,” says Martellini, scientific director of the Edhec Risk and Asset Management Research Centre. “The data that we have tends to suggest that these products underperform their targets.” Given that hedge funds are not an asset class but a diverse set of strategies, Martellini questions the value of replicating a broad index. “It is better to try to replicate at the strategy level,” he says. AlphaSimplex chairman Lo concedes that replication products don’t make sense for traditional hedge fund investors who want 20 percent or 30 percent returns with commensurate risk. He says that clones should appeal inPhotograph by Mark Hartman 56 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2009
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