Less is more

Hedge Fund Replication

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Plain old beta wouldn't normally be first choice as a selling point for a new product, especially when your target market includes alpha-hungry hedge fund investors. But judging by the handful of so-called portable beta launches over the past few months, a smattering of players see a burgeoning market for automated products that offer pretty humble returns compared with the best-performing managers - but at a cut price.

Merrill Lynch, Goldman Sachs and two Swiss asset management companies, AlphaSwiss and Partners Group, have been the first to take the leap. The individual products target slightly different markets and play with different underlyings, but the driving force is essentially the same. They all seek to offer investors access to non-manager-specific industry-wide returns in a transparent and price-efficient format - in other words, they offer cheap beta.

"What we're distinguishing between here is alpha, which is due to manager skill, and beta, which is due to general market movements," says Steve Umlauf, managing director in the strategic solutions group at Merrill Lynch in New York. All the institutions involved told Risk they weren't seeking to replicate or directly compete with alpha-generating fund managers. "We do think there is alpha available out there through good fund managers," says Umlauf. "And if you can identify it and get access to it then it's worth paying for. But if it's just beta you're getting, then it should be sold like an index fund - that is, in a liquid, low-cost, transparent format."

The building blocks for portable beta products trace their roots to academic studies into hedge fund returns over the past 10 years. In one paper, published last August by the Massachusetts Institute of Technology's Andrew Lo and Jasmina Hasanhodzic, the authors tested the premise that a significant proportion of industry-wide hedge fund returns can be attributed to general market movements - in other words, the majority of managers create little additional value.

The results were startling. The academics tracked 1,610 global hedge funds and constructed a proxy fund with exposure to the main sources of beta for the sample - traditional equity and emerging markets, for example. Shockingly, over the period 1986-2005, the proxy fund achieved 70-90% of the average returns and volatilities of the sample just by riding out market shifts in the beta-generating markets. That would imply that dynamic trading by managers accounted for only a small proportion of returns in that period.

Key to replicating these returns was working out what proportion of capital needed to be allocated to each of the beta-generating markets to create comparable return levels. The academics found that, by applying a simple linear regression (a mathematical technique that models the relationship between variables in a dataset) to a hedge fund index's behaviour over time, they could calculate how to divide their capital between various markets to generate similar returns. On a simple level, they could analyse a hedge fund's performance over 10 years and then determine the proportion of capital that should be invested across various liquid equity cash and futures markets to replicate those returns.

Harry Kat, a professor at the Cass Business School in London, has observed a similar trend. "Based on our research, we estimate that in 70-80% of the cases, a hedge fund manager's contribution to the after-fee bottom line is zero or negative," he says. "Investors basically allow the manager to make a very good living using their money without getting anything in return. Unless one is genuinely attracted to this form of charity, in these cases it is worth replacing the manager in question by a synthetic fund."

The institutions stepping into the portable beta space believe they have spotted a potential niche. They are hoping to snap up investors unhappy with the after-fee returns from their hedge fund investments, and promise to offer comparable average returns in a liquid index-like format for an annual fee of around 1% - significantly lower than the standard 2% management fee plus 20% performance fee at many hedge funds.

Switzerland-based Partners Group launched its alternative beta fund in October 2004. The product was developed from a benchmark the firm created for its fund-of-funds business, and uses a combination of linear regression and in-house research of existing fund strategies to decide how capital is allocated between liquid markets such as the S&P 500. It has already attracted some $600 million of investment.

"It doesn't matter who was first and second, this is going to have a dramatic impact," says Lars Jaeger, head of alternative beta strategies at Partners Group. "I've already talked to several parties who are interested in launching something quite similar and it's going to be very big." He says that it is only a matter of time before more big investment banks and some of the index companies launch their own offerings in this market. Indeed, some participants predict portable beta could make up 40% of total hedge fund assets in just a few years' time.

Different approaches

The strategies displayed by the two investment banks that have already launched products show some difference of opinion over the target market of such technology, however.

Merrill Lynch is targeting institutional clients seeking cheap, liquid and diversified beta and has already sold more than $100 million of its Hedge Fund Beta Correlation Index since it was launched in mid-2006, mainly to pension and insurance funds. The product references a basket of hedge fund strategies and replicates its beta returns by investing only in the S&P 500, the MSCI Europe, Australasia and the Far East index, the MSCI emerging markets index, the US dollar index, the Russell 2000 index and Libor. It is currently launching sub-indexes of its main product that can offer investors pure beta exposure to specific hedge fund strategies, such as convertible arbitrage or market neutral.

Goldman Sachs, on the other hand, has chosen to target only the retail market with its Absolute Return Tracker fund. So far, due to regulatory hurdles, it has only managed to gain approval in Italy and is cagey about just how much of the product it has sold. Nevertheless, it is actively seeking approval in other jurisdictions.

Despite this interest, critics claim linear regression of historical data - the technique used in most of the portable beta structures so far - is a fundamentally flawed way to allocate capital. Despite investing only in liquid markets, and thereby reducing liquidity risk, beta funds have little leeway to react to changing market conditions.

That's because most of the funds available analyse hedge fund indexes on a monthly basis, and readjust their portfolio allocation according to the linear regression analysis results. As a result, critics say the investment strategy is based on historical, rather than current, market conditions and could potentially open up investors to increased market risk.

"One of the best things about hedge funds is that they are quite dynamic and can react to market conditions in relatively little time," says Erik Larsson, head of research at Zurich-based AlphaSwiss. "But if you track these kind of indexes of funds, the opacity of funds guarantee that you will have at least a monthly lag. That's not very dynamic." AlphaSwiss uses a combination of manager-input and linear regression to formulate its alternative beta strategy.

Critics also point out that by only investing in more liquid markets, much of the liquidity risk premiums from which many hedge funds derive their returns will be forgone, making it even harder to replicate returns. Nonetheless, talk is already brewing that the introduction of such strategies could have a secondary impact and might one day revolutionise the way potential clients manage their investments. Shorting the hedge fund beta indexes will allow investors to strip out and isolate an individual manager's performance - enabling them to obtain pure alpha.

At the same time, if the portable beta products outperform some funds post-fees, it might just force some underperforming managers to cut fees or leave the industry. Or so the theory goes, at least.

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