Institutional Investor's Alpha Magazine - March 2009 - (Page 57) Hedge Fund Replication stead to institutional investors seeking LIBOR-plus-300 basis points, which would come to about 5 percent annually, at current rates. “If you’re a pension fund looking to get diversification from a portfolio that’s largely concentrated in stocks and bonds, then making a 5 or 10 percent allocation to a hedge fund beta product is a tremendously valuable way of getting exposure to those alternative asset classes,” Lo reasons. But he cautions that building and running a replication strategy requires good judgment, economic intuition and constant vigilance: “This is one of the reasons hedge fund beta strategies, while they sound simple and appealing, at this point in time still require a fair bit of expertise to undertake.” AQR Capital Management is nonetheless betting on hedge fund beta — but not under the formal banner of replication. The firm, which manages some $20 billion in alternative and traditional assets, in October launched what it calls its Delta strategy. Adam Berger, who heads the portfolio solutions group at AQR, says the firm avoids calling the new fund a replicator. But that’s what it is. Delta — for dynamic economically intuitive liquid transparency alternative — takes a bottom-up approach. Unlike top-down replicators, such as the clones offered by Merrill and Premia, which mirror the funds in a target index, Delta constructs individual strategies from scratch by trying to build diversity; for example, a merger arbitrage strategy would aim to take a position in every merger deal transpiring. AQR then rolls these strategies into a single product. “If you want a strategy like merger arbitrage or convertible arbitrage, for the most part you have to go to a hedge fund to access that risk,” Berger says. “We think we can give it to people outside a hedge fund’s two-and-20 structure.” Berger says top-down clones hold too few assets to capture the granularity and richness of hedge funds: “In many cases, they tend to be just repackaging risks that investors already have elsewhere in their portfolios.” Berger anticipates that Delta will have about $150 million in assets as of this month, most of it from institutional investors. The fund has two fee levels, depending on whether investors choose a lower-risk or a highervolatility strategy. Each offers the choice of a flat rate or a management fee plus a performance fee. Berger, however, declines to disclose what they are, saying only that fees are “much lower than an investor would pay for a comparable hedge fund or certainly a fund-of-funds investment.” He also declines to reveal returns, but says Delta was up in October and November. Hedge fund losses during that time had less to do with the strategies those funds were using than with market returns almost anybody could have gotten, he notes. “The fact that we exclude that passive market piece — which seems to dominate the hedge fund index returns — has worked in our favor these past few months,” he says. New York–based Credit Suisse Alternative Capital is also pursuing a strategy-specific approach with its longshort equity replication index, launched last March. The first in a suite of its Alternative Index Replication offerings devoted to individual hedge fund strategies, the index came out of a consulting partnership with professors Fung, Hsieh and Naik. It was down 16.6 percent in 2008. Its benchmark, the Credit Suisse/Tremont long-short equity hedge fund index, fell 19.8 percent. To show investors how they might fare with short exposure to the common factors behind the long-short equity sector, the firm also publishes the Credit Suisse inverse long-short equity replication index, which was up 16.7 percent in 2008. Jordan Drachman, Credit Suisse’s head of research for alternative beta strategies, says a broader hedge fund index would have required taking into account all the factors one might use to model various subindexes, an exercise that isn’t feasible, he argues. And besides, such a model may outlive its usefulness if, say, global macro displaces long-short equity as the dominant strategy in the hedge fund world. By comparison, Drachman explains, the risk-return profile of an individual strategy remains fairly constant: “The trades the managers do are different, from time to time, but the strategies don’t change that much.” Hsieh foresees a second generation of replicators that will adopt specific hedge fund strategies — but with different allocations than those of the average hedge fund. “This will generate returns that are less correlated to the “The past few months have awakened individuals and institutions to the value of liquidity. ” — ANDREW LO, MIT SLOAN SCHOOL OF MANAGEMENT average hedge fund, and therefore less correlated to the stock market,” he says. Berger, who acknowledges that a firm without AQR’s resources would have trouble launching a strategy like Delta, says recent market conditions will compel investors to reconsider their commitment to their hedge fund portfolios. He thinks hedge fund beta strategies will win out because they have advantages hedge funds can’t necessarily match: better returns and low correlation to the rest of one’s portfolio, along with more transparency and comparatively reasonable fees. “For many people, this is the wave of the future,” Berger says. “The development of market-cap-weighted stock indexes was transformative for how people invested, and hedge fund beta could prove to be the same thing.” MARCH 2009 • INSTITUTIONAL INVESTOR’S ALPHA • 57
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