Click here for printer friendly page
Alternative routes to hedge fund return replication10/06/2008. Source: Harry M Kat.
 Although institutions are still pouring more and more money into hedge funds, hedge fund performance is clearly deteriorating. In part, this reflects lower interest rates and a global decline in risk premiums. Part of hedge funds' disappointing performance, however, is also due to the huge flows of institutional money itself, writes Harry M Kat.
Although some strategies are more sensitive to over-investment than others, the commoditisation and institutionalisation of hedge funds is not doing investors any good. Of course, things would be quite different if hedge fund and fund of funds managers didn.t charge the kind of excessive fees that they do. With interest rates and risk premiums at historically low levels, taking '2 plus 20' amounts to splitting the pre-fee fund return 30/70 between manager and investor. When a fund of funds introduces a second layer of fees, this deteriorates to 40/60.
Driven by a desire to reduce costs and improve investor returns, as well as to avoid the many other drawbacks surrounding hedge fund investment, such as illiquidity and lack of transparency, the market has recently seen several attempts to "replicate" hedge fund index returns. The latter have received quite some attention in the media and among practitioners, but without detailing the workings of the various approaches and their shortcomings. In this paper we highlight the differences and similarities between the different approaches and comment on the attraction of the resulting investment products as portfolio diversifiers.
Judging from the various comments made at conferences and on the internet, there seems to be some confusion among practitioners about what drives hedge fund return replication and what it is meant to achieve. Put simply, hedge fund return replication is about generating hedge fund-like returns by mechanically trading traditional asset classes. The idea is not, as some commentators seem to think, to replicate the performance of the 'best' hedge funds in the business. More modestly, the goal is to replicate the average.
The driving force behind hedge fund replication is the realisation that the majority of hedge fund (of funds) managers do not have enough skill to make up for the fees that they charge. If this is true, investors basically allow hedge fund managers to make an extremely good living using their money, while ending up with deflated after-fee performance themselves. This makes it worthwhile to replace the managers in question with a synthetic hedge fund. Synthetic hedge funds produce no pre-fee alpha,
but they don.t cost a fortune to run either and may therefore very well produce significant after-fee alpha. In addition, synthetic hedge funds come with great improvements in liquidity, transparency, capacity, etc.
Who should invest in synthetic hedge funds? In the end, it all depends on how confident an investor is of his ability to find those truly skilled hedge fund (of funds) managers (and talk them into allowing him invest with them). Investors who are confident they have enough skill to successfully identify those managers that will more than make up for the fees that they charge, should do so. Synthetic hedge funds are not for them. However, for those who realise how good one.s manager selection skills will need to be, to be successful, synthetic hedge funds are an alternative well worth considering.
Click here to view the full document (pdf 333KB) You need Adobe Acrobat to read this document. If you do not have it, you can download it free from www.adobe.com/products/acrobat/readstep.html
Harry M Kat is professor of Risk Management and director, Alternative Investment Research Centre at the Sir John Cass Business School in London. Go to www.fundcreator.com.
|
