Six Reasons To Replicate Hedge Funds
Hedge funds have proven diversification benefits. That said, there is a growing consensus that high hedge fund fees too often mean that managers get rich even when performance suffers. In fact, over the five years, a typical hedge fund portfolio generated 442 bps per annum of alpha before fees, but only 63 bps after fees – a loss of over 85%.[i]
In recent years, “liquid alternative” hedge fund-like mutual and UCITS funds – intended to bring those diversification benefits to a broader audience of investors -- have been met with disappointment due to poor performance, often high expenses, and/or unpredictable returns. Case in point: multi-alternative mutual and UCITS funds – designed to provide diversified exposure to more liquid hedge fund strategies – have under-performed actual hedge funds by one-third to one-half over the last five years, even with lower all-in fees.[ii] Such “systemic” performance drag materially undercuts the diversification thesis.
Today, many sophisticated investors are seeking alternative ways to gain the benefits of hedge funds but with liquidity, lower fees, and less risk. Hedge fund replication, pioneered before the financial crisis by a select group of academics, investment banks, and asset management firms, has been a proven way to achieve this. The following are six key reasons to consider it:
1.Replication is a time-tested approach that seeks to match or outperform actual hedge funds.
Replication strategies employ quantitative models that seek to match or outperform hedge funds by investing directly in the market factors that drive performance. “Top down” replication products introduced before the crisis (including products launched by investment banks such as Goldman Sachs, Merrill Lynch, and Credit Suisse) have generated around 100 bps her annum of alpha relative to actual hedge fund portfolios.[iii] [A more recent approach, portfolios that invest in hedge fund-like trading strategies (“alternative risk premia”), has not fared as well: The Clear Alpha Global Index[iv] of such products offered by banks returned approximately half that of hedge funds over the past five years.]
2.The success of replication is grounded in research on what drives hedge funds performance.
Replication captures two important sources of hedge fund performance: security selection and asset allocation. Security selection can drive performance of a single fund; however, for a portfolio of funds, repeated successful security selection results in alpha-generating factor tilts. In 2005-07, hedge funds as a group had 30% or higher exposure to individual stocks in emerging markets; when those markets outperformed the S&P 500[v] by 26% per annum, this “factor tilt” generated alpha of approximately 800 bps per annum. For certain strategies like managed futures, a limited number of positions in key markets (long or short equities, rates, certain currency pairs, etc.) drives performance over time. A well-designed replication model identifies hedge fund exposures across key markets and invests directly in liquid market factors, in the appropriate weights, to deliver similar or better performance.
3.In our opinion, replication can materially outperform on a “liquidity-adjusted” basis.
Most investors demand a 3% or higher return “premium” for investing in illiquid assets. During the financial crisis, investors experienced the risk of illiquidity when many hedge funds failed to return capital to investors (gating or suspensions), and often had to sell other assets at discounted prices. A strategy with daily liquidity, like replication, is inherently more valuable if it can match the performance of an illiquid one – by this measure, outperformance of 100 bps per annum equates to 400 bps of outperformance on a “liquidity-adjusted” basis. While some hedge fund strategies, like structured credit, do focus on illiquid underlying investments, most hedge funds invest primarily in liquid stocks, bonds, and other instruments. Replication captures the performance associated with those liquid investments without high fees; hence more of the benefit flows to investors.
4.Replication eliminates or minimizes “single manager” risk.
Most investors seek diversified exposure to hedge funds – recognizing that picking one or two individual funds is as risky as betting on a single stock. The average dispersion between top and bottom decile funds typically is 30% or more in any hedge fund category[vi], and the prior year’s top performers on average are in the 51st percentile in the coming year.[vii] Further, drawdowns of individual funds are double or more those of the typical diversified portfolio – the reason institutions prudently spread their bets across a dozen or more funds. Top-down models that replicate the performance of a diversified pool of hedge funds capture the diversification benefits of the target portfolio and hence are lower risk than individual hedge funds or liquid alternatives.
5.Replication can minimize “hidden” risks and drawdowns.
During 2008, top-down replication strategies outperformed actual hedge funds when illiquid assets were marked down excessively during the liquidity crisis. Similarly, in 2015-2016, when individual hedge funds stocks underperformed the overall market by 1000 bps or more, replication strategies outperformed again. Both those risks are endemic to actual hedge funds and, to a certain extent, liquid alternative products managed by hedge fund managers. Replication avoids those risks by investing only in highly-liquid, exchange-traded futures and ETFs. [By contrast, alternative risk premia products are more likely to be subject to gap risk given trade crowding and the conditional liquidity of many underlying instruments.]
6.Low fees can be a meaningful source of alpha.
Early top down replication strategies sought to match the returns of hedge fund indices; post-crisis, Beachhead and others sought to deliver additional alpha by targeting “pre-fee” performance. In some strategies, like managed futures, replication can deliver all pre-fee returns – in essence, giving investors a 300 bps “head start” relative to investing in high cost hedge funds. For equity long/short and many other hedge funds strategies, replication portfolios can outperform materially by capturing 80% or more of “pre-fee” performance and charging lower fees. In this way, fee disintermediation may be a way to generate alpha.
What are the limitations? First, replication works for portfolios of funds, not individual funds. Replication also does not work well for highly illiquid strategies, since a high percentage of pre-fee performance comes from the illiquidity premium. Finally, top-down replication has not proven effective with hedge fund strategies that deliberately minimize any clear market exposures (some quantitative arbitrage strategies).
Replication strategies can bring meaningful value to most investors’ portfolios. Traditional allocators to hedge funds can employ a core-satellite model and pair low cost, liquid replication strategies with non-replicable hedge fund strategies to generate higher returns with better liquidity and lower fees. Retail investors can improve diversification while investing only in regulated funds, like mutual funds and UCITS vehicles. And finally, allocators who build diversified model portfolios can match or outperform the hedge fund indices used in capital market assumptions, but without single manager risk or high fees.
Andrew D. Beer is Founder and Managing Partner of Beachhead Capital Management.
[i] HFRI Fund of Funds Index, 2013-2017. Alpha calculated relative to the MSCI World index using monthly data. Pre-fee calculations assume fund of funds fees of 1% and underlying manager management fees of 2% in addition to a 20% performance fee paid annually.
[ii] For mutual funds, an equally-weighted composite of large alternative multi-manager 40 Act funds from 2013-2017 against the HFRI Fund of Funds index (source: Bloomberg). For UCITS funds, an equally-weighted composite of all UCITS funds of funds in the HFR database for 2013-17 against the HFRI Fund of Funds index (source: Hedge Fund Research). Returns are shown net of fees. Liquidated funds are included until their last reported full monthly performance.
[iii] Goldman Sachs Absolute Return Tracker Index, Merrill Lynch Factor Index and Credit Suisse Liquid Alternative Beta Index vs. the HFRI Fund of Funds index from 2008 to 2017. Note that the indices have been adjusted for assumed fees of 0.75% per annum.
[iv] The Clear Alpha Global Index is designed as a benchmark for the universe of trading strategy indices. It is calculated and published daily, and its constituents and their respective weights are updated once a quarter. (source: Bloomberg)
[v] MSCI Emerging Markets Total Return Net vs. S&P 500 Total Return from 2005 to 2007. (source: Bloomberg)
[vi] Average annual difference between the top decile performers and the bottom by strategy in the HFR database since 2007. (source: HFR, Beachhead calculations)
[vii] Average percentile performance for single-manager funds in the HFR database that were in the first decile over the previous year. (source: HFR, Beachhead calculations)