AQR`s Cliff Asness: Replication of HF returns could a very good thing for the industry From www.hedgeworld.com 1/11/7 NEW YORK (HedgeWorld.com)—Cliff Asness, founder of New York-based hedge fund AQR Capital Management LLC, thinks cloning himself would be a mistake. But when it comes to cloning some of the alpha Mr. Asness has been delivering to his investors? Click here to read on..
Alpha, once beatified, now “beta-fied” From www.allaboutalpha.com 29/10/7, 29 October 2007
It was only a couple of years ago that David Hsieh made an off-the-cuff remark that many took as a questioning of the long-term viability of the hedge fund industry (see related posting). Click here to read on..
Matthias Knab reports "live" from the IRC "Hedge Fund Replication and Alternative Beta" conference in Geneva by:http://www.opalesque.com/
With more research and available products, hedge fund replication and alternative beta is catching on. Credit Suisse / Tremont for example believes that "replication is a natural extension of indexing". Click here to read on..
Day Two in Geneva: black swans, a new way to clone and new research on persistence
27 September 2007 http://allaboutalpha.com/blogTaleb: Definitely not a normally-distributed kind of guyDay two was kicked off by a thought-provoking presentation by Nassim Nicholas Taleb, author of several best-selling books about risk, including: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and recently: The Black Swan: The Impact of the Highly Improbable.Please visit http://allaboutalpha.com/blog to see full article with images.
Overheard at the President Wilson
26 September 2007 http://allaboutalpha.com/blogHere are a few more tidbits from the Hotel President Wilson here in Geneva… “I’m thinking about launching an index fund of replicated hedge fund index funds!” John Godden, IGS Group, jokes about a fund of funds to replicate the replicators. Click here to read on..
Hedge Fund Replication: Day One Re-cap
26 September 2007 http://allaboutalpha.com/blogAlpha Male has attended more hedge fund conferences than he cares to remember. Many of them have begun with several empty seats and ended with far more. But apparently the good citizens of Geneva know a hot financial topic when they see one. You know all those seats along the back wall for late comers? Click here to read on..
Heard by the waters of Lake Geneva,
25 September 2007 http://allaboutalpha.com/blogHeard on the floor at Terrapinn’s “Hedge Fund Replication & Alternative Beta” conference in Geneva so far today… “His trading process may be “naive”, but his fees sure aren’t!”- Professor Harry Kat on the hedge fund replication strategy pursued by another well-known firm. Click here to read on..
A Beta Way To Boost HF Returns, From InsitutionalInvestor.com, 21/9/7
The secret ingredient to boosting performance of a hedge fund portfolio is some alternative beta, according to Stonebrook Capital Management. In fact, a first-of-its-kind study conducted for the New York-based firm that specializes in AB, says 30% is about the right mix. Click here to read on..
State Street Quietly Launches Hedge Fund Clone, HEDGEWORLD 18 September 2008
BOSTON (HedgeWorld.com)—State Street Global Advisors is the latest asset manager to launch a hedge fund replicator, following close on the heels of such firms as Goldman Sachs, Barclays and, most recently, Morgan Stanley. The new product has been running since July with seed capital from SSgA. Click here to read on..
T-Rex (Total Return Exposure) strategy to synthetically replicate synthetically HFR Index performance: From Structured Products Online.com: 7 August 2007SGAM AI’s new Ucits fund replicates hedge funds
SGAM Alternative Investments (SGAM AI) has launched a Ucits-III compliant mutual fund using the concept of the T-Rex (Total Return Exposure) strategy Click here to read on..
All about Alpha, 15 March 2007, Professor Harry Kat responds to EDHEC study on hedge fund replicationAfter yesterday’s story on EDHEC’s new hedge fund replication research, we were curious about Harry Kat’s take. With some cajoling by us, Professor Kat responds below…By: Prof. Harry Kat, Cass Business School, City University (London). Click here to read on..
Global Pensions, 12 March 2007, Place Your Bets: Investible Indices vs. Replication Strategies
Pension fund demand for hedge fund indices is minimal and the advent of replicator funds could deal a death blow to them, some of the world’s largest consultants have claimed.But FTSE Group alternatives business unit head Gareth Parker insisted passive indices would play “a very big role” in the hedge fund market going forward.Click here to read on..
NEW YORK (HedgeWorld.com)—Cliff Asness, founder of New York-based hedge fund AQR Capital Management LLC, thinks cloning himself would be a mistake. But when it comes to cloning some of the alpha Mr. Asness has been delivering to his investors? That's another matter. If done well, replication of hedge fund returns will be a "very good thing for the industry," Mr. Asness said earlier this week at a conference on hedge fund replication and alternative beta organized by Terrapinn. As the founder of one of the world's largest hedge funds and a quantitative investing specialist, Mr. Asness has a good perspective on hedge fund replication, a statistical technique that aims to replicate hedge fund returns using models. The notion, pioneered by academics, has now gained a strong foothold on Wall Street, with several banks such as Goldman Sachs Group Inc., JPMorgan & Co., Merrill Lynch and Morgan Stanley delivering their own replication models. Prior to founding AQR, Mr. Asness headed the quantitative research group for Goldman Sachs' asset division. It makes sense for hedge fund managers to pay attention to the direction in which the industry is evolving. Replication is a new form of passive investing. Cloning is supposed to give investors hedge fund-like returns at a much lower cost with the added benefits of liquidity and transparency. Because of that, some say the innovation carries with it a potential threat to hedge fund managers. The reaction among hedge funds has varied based on two components. Cliff Asness: Replication of HF returns could a very good thing for the industry
The first is the hedge fund manager's ability to generate alpha. Mr. Asness, no doubt, falls into the alpha generator category. Alpha is related to a manager's skill, in contrast to beta, which refers to the part of investment returns generated by the market. The second aspect lies in what hedge fund replication can and cannot do. For the most part, clones have replicated hedge fund beta. For managers whose returns are largely beta-driven, cloning may be a threat. But the best managers may see things differently if they believe, as Mr. Asness does, that clones can offer some level of alpha. Most hedge fund replication models have a humble purpose: Their creators always say as a disclaimer that they aim to replicate the beta generated by hedge fund; not the alpha. If that's all there is to it, Mr. Asness' view becomes clear. "We're not saying that hedge fund replication is a good thing," he said. "We're saying it's a bad thing." With respect to replication, Mr. Asness said, "Not everything that can be done should be done." Still, he said AQR is looking into replication as a possible business. If it sounds like a paradox, it may be only because AQR likes the challenge of trying to make a "bad idea" a good one. The bad idea is to replicate beta. The good one may be to offer more alpha. "We wrote a lot on the stock market beta in hedge funds. Our point was that beta was the bad part of hedge funds," Mr. Asness said.
The second point Mr. Asness made clear is that there is undue confusion between quantitative investing and hedge fund replication. Quant managers run black boxes that by definition cannot be transparent, while hedge fund replication models target pure transparency. "You can't be a black box and easily replicated at the same time," Mr. Asness said. "You can call me one or the other, but you can't call me both." Looking at the initial body of research into replication conducted at AQR and disclosed in part by Mr. Asness during the conference, one finds that the model was inspired by the work of Mark Mitchell and Todd Pulvino, two academics who pioneered a replication method called rule-based replication in a groundbreaking study published in 2001 in the Journal of Finance. In their research, the two academics created an index for merger arbitrage returns using a set of predefined investment rules. Both men now work at AQR as principals and co-founders of CNH Partners, the merger arbitrage and convertible arbitrage affiliate of AQR. The rule-based methodology has been implemented by Partners Group with its Alternative Beta product and by Merrill Lynch with its ML Equity Volatility Arbitrage index. The other trading approach, factor-based trading, is used by the majority of the industry and uses statistical regression models that mimic the returns of a hedge fund index or sub-index.
The model presented by Mr. Asness established a high degree of correlation between several identified strategies and Credit Suisse/Tremont Hedge Fund Index returns from 1994 to today. In statistical jargon, one measure of the degree to which a fund is correlated with a benchmark is called R-squared. Specifically, R-squared represents the percentage of a strategy that can be explained by the movements in a benchmark index. A 100% R-Squared means that the strategy can be fully explained by market moves. Some of the most correlated strategies were event-driven and emerging markets. Both had R-squared measurements of 69%. The most correlated strategy was long/short equity with an 81% R-squared. Perhaps this is due to the long bias of this strategy, something that is intuitively known but that AQR confirmed in its model. "Equity long/short tends to play the momentum in almost every way," said Mr. Asness. "Equity long/short is never short." quity market neutral, a style often run by quants, offered an R-squared of 41%. The model showed that equity market neutral managers tend to be net long global equity as well as net long equity volatility and net long bond volatility. That means "they do well when bad things happen anywhere, which raises their alpha," said Mr. Asness. Market neutral strategies, especially those implemented in a quantitative style, did suffer losses this summer in the first week of August. But Fixed-income arbitrage offered a mixed degree of correlation with a 48% R-squared. Mr. Asness noted the importance of the positive carry in this strategy, as managers are long bonds when the yield curve is positive, or when short-term bonds have a lower yield than long-term bonds. In the carry trade, investors buy high-yielding bonds on the long part of the yield curve and sell lower yielding short-term instruments on the short part of the curve, making a spread on the interest rate differential. The more positive the curve is, the higher the spread. Additionally, a lot of the returns for those managers are due to their "massive" long positions on the fixed-income premia, Mr. Asness said. Simply put, managers create alpha by investing in illiquid assets.
An index return also would be hard to replicate with a global macro strategy. With a 30% R-squared, the strategy has a low index correlation. Global macro managers are long global equity and long small stocks. They are long momentum strategies on both bonds and currencies. And they also employ a carry trade strategy on the foreign exchange market, buying strong currencies with a high yields and selling weak currencies with lower yields. Commodity trading advisers also appear to produce returns difficult to replicate, with a 33% R-squared. They are long the fixed-income volatility and follow the momentum in the bond and currency markets, said Mr. Asness. That said, CTA managers do not display much style drift. "These guys say they're trend-followers and the data show they're trend-followers," said Mr. Asness. "They're doing what they say they're doing."
Mr. Asness said AQR did not attempt to model multi-strategy. "It doesn't fit my model," he said. Mr. Asness warned that by using an index for his model—the Credit Suisse/Tremont Hedge Fund Index—he did not account for some biases, such as survivorship bias. He also did not take into account transaction and leverage costs. But the picture is clear enough to offer a simple conclusion: In the past 10 years both the Credit Suisse hedge fund index and the replication model were highly correlated to the markets. "Here is the dirty little secret of replication: There is a pretty massive equity correlation," he said.
Looking at the correlation of his model to the Standard & Poor's 500 stock index versus the correlation of the Credit Suisse/Tremont Hedge Fund Index to the same benchmark, both for the past three years, Mr. Asness said that the hedge fund index showed a correlation of 0.71 versus 0.9 for his replication model. Interestingly, this correlation trend is recent. Ten years ago, both the AQR model and the hedge fund index showed lower levels of correlation to the S&P500 index at 0.65 and 0.41, respectively. Those results suggest that there is no alpha in clones. Therefore, one would conclude—too rapidly—that an alpha generator hedge fund manager, as AQR is, would have little interest in developing replicating tools. After all, cloning does not create what investors are paying hedge funds to deliver: alpha.
But that would be the wrong conclusion. In his concluding remarks, Mr. Asness said that replication really only boils down to three factors: being long stocks, being long small stocks and using a portfolio insurance strategy. Portfolio insurance is a hedging technique against market risk consisting of short selling stock index futures. "What I like about those results, is that it points out the lack of magic behind hedge funds. It also shows that there is potential for fee pressure. And there is potential for alpha, what I do for a living," said Mr. Asness. "If I do one [a hedge fund replication model], it would have a very low base fee and a respectable performance fee versus the hedge fund indexes" he said. Essentially, Mr. Asness said he believes he can do it with alpha and get paid for it. "It's of great interest to me. Even if I'd argue with replication as a goal, clearly many want alpha exposure. And if you can do it, with alpha net of fees, more power to you." So far, Mr. Asness has only produced an internal model, a scratch book for future developments. And so he would not jump the gun. "By the way," he said, "I am not doing a hedge fund replication product. I certainly might one day. But I don't."
However, asked during a follow-up interview if he was optimistic about hedge fund replication, he said, that "Yes, I am relatively positive about it." He said he is not concerned that such technology will "cannibalize" his hedge fund franchise. "It won't because our hedge fund returns are not correlated to the market," he said.
What really matters is how one separates alpha from beta. It will become more lucrative for the good managers to prove that they can generate alpha. Hence, there won't be any fee pressure for that category of managers. But who is to say that hedge funds cannot develop other business models for the delivery of alpha? Whether managers deliver alpha as active managers through a traditional hedge fund or passively and synthetically through the development of replication models should not make a big difference. Investors will always pay for alpha.
Alpha, once beatified, now “beta-fied” From www.allaboutalpha.com 29/10/7, 29 October 2007
It was only a couple of years ago that David Hsieh made an off-the-cuff remark that many took as a questioning of the long-term viability of the hedge fund industry (see related posting). He estimated that around $30 billion of alpha was available to hedge fund managers. This immediately started a round of navel-gazing in the industry the led to a number of competing estimates of the total supply of alpha in the world (such as this one by Lars Jaeger). Was alpha going to run out? Would the party be over soon? Was there a “peak alpha” theory? These became the dominant questions of 2006.
Now it appears those concerns were so “last year“.
Both Hsieh and Jaeger were among a dozen experts to address a packed audience in New York today at the inaugural US edition of Terrapinn’s “Alternative Beta & Hedge Fund Replication” conference. This time aorund, Alpha Male took a turn at being master of ceremonies. (see related postings on sister events in London and Geneva earlier this year).
Instead of worrying about the finite size of the world’s alpha supply, Hsieh, Jaeger et al argued that hedge funds would likely survive on a diet of “alternative beta” even if their traditional food source (alpha-generating market inefficiencies) ran out.
Rather than predicting the imminent demise of hedge funds, most of the speakers here actually argued that hedge funds have now become a delivery mechanism for alternative betas (whither “alpha”?). Even the institutional investors who took the podium today accepted the notion that hedge funds can be justified even if much of their returns were “hard to find” betas.
In doing so, they essentially revisited the accusation often leveled against hedge funds that they simply “sell beta at alpha prices”. It seems that many now believe that hedge funds are right to charge alternative beta prices for alternative beta. In other words, the industry may have reached a rare consensus with investors that alpha may not be as mystical as initially billed - but that hedge fund returns still cannot be easily replicated by simply buying ETFs. One speaker even warned the audience “Don’t underestimate the value of alternative beta”.
It’s clear that institutional investors have set a high bar for hedge fund managers. In order to justify so-called “alpha-fees”, hedge funds now need to prove they are delivering returns that cannot be found in less exotic forms (e.g. Deutsche Bank’s currency or commodity trades, Fung & Hsieh’s straddles, Kat’s exotic options). But what’s less clear is whether institutions also plan to beat up long-only managers about whether their alpha is actually just alternative beta. Ironically, the alpha portion of long only returns receives significantly less due diligence and is significantly less transparent that a typical (institutional) hedge fund. How do we know this? Because if their strategies had to undergo the same cavity searches as hedge funds, then the study of “alternative beta” would already be well established.
Oliver Schupp from Credit Suisse Tremont suggested that indexation (2004’s burning issue) would soon give way to replication. Like hedge fund indexation, he argued, hedge fund replication provided similar benefits to those upon which so many investable hedge fund indexes were built.
Merrill’s Benjamin Bowler said that liquid hedge fund replication products had many uses: providing long and short hedge fund exposures (especially where institutional mandates don’t allow hedge fund investments), liquidity management, portable alpha, derivatives/capital preservation, and benchmarking.
In a panel discussion to end the day, Investcorp’s Chris Acito reminded the gathering that most alpha “eventually becomes beta”. But he also added that alpha can also just disappear as it is arbitraged into oblivion. Alpha, he said, will only become (lasting) beta if it delivers a fundamental risk premium. (The Ford Foundation’s Larry Siegel actually coined the term “beta-fied” at 4:30pm today).
In the end, it appears that if hedge funds ever run out of alpha, then will have a viable second career second career delivering alternative beta. And while driving an alternative beta delivery truck is a far cry from being beatified, it sounds like it would more than likely pay the bills.
Matthias Knab reports "live" from the IRC "Hedge Fund Replication and Alternative Beta" conference in Geneva by:http://www.opalesque.com/
With more research and available products, hedge fund replication and alternative beta is catching on. Credit Suisse / Tremont for example believes that "replication is a natural extension of indexing". Matthias Knab reports "live" from the IRC "Hedge Fund Replication and Alternative Beta" conference in Geneva:
Fung: Hedge fund replicators not to replace hedge funds, what`s behind the Black Swans
Prof. Bill Fung, BNP Paribas Hedge Fund Centre, London Business School started his "Brief history of hedge fund replication and the origins of alternative beta" introduction with likewise brief definitions, saying that alternative alpha is people investing, and alternative beta is strategy investing as "matured, rule-based strategies whose returns are cheap to replicate"
Fung said replication strategies are not here to replace hedge funds or hedge fund managers. He defines them as a "class of strategies to supplement the existing strategies available to investors".
Risk management, modeled from real hedge funds must be integrated Taking a look at the dynamics of hedge fund replication, Fung said it is imperative for hedge fund replicators to include risk management skills, and not only look at asset classes and strategies. Replicators have to "look at hedge fund managers" and integrate best practice risk management, taking into account liabilities created by leverage. Dynamic allocation of risk capital should be a part of a hedge fund replication. According to Fung, hedge fund replication is a tool "to construct a better portfolio".
Alpha-positive August results (for example JP Morgan and SSGA) show that "it works if you add risk management to your replication strategies", contradicting conventional wisdom usually cited in such months like "when markets go bad, they go bad all together". Giving conventional wisdom a second thought, Fung said following this argument would ultimately mean that diversification does not work, nor short strategies. Or, from another angle, that credit spreads are linked to statistical arbitrage models etc.
Black Swans
Addressing the "Black Swan" phenomenon, which is haunting the hedge fund world, Fung said the more you leverage, the more you get black swans. The problem would be intensified as "all hedge funds borrow from the same small group of investment banks."
On each prospectus we print "past performance does not guarantee future results" - yet we all dissect return tables. What for? Conversely, we say "you cannot drive a car staring at the rear mirror" - and yet it is illegal to drive without a rear mirror. According to Fung, we analyze past returns and use rear mirrors "in order to better manage what to come...at the lowest cost." And these cost advantages are the really at the core of all replication efforts.
Gavyn Davies` Fulcrum Asset unveils alternative beta product `Fulcrum Alternative Beta Plus`
Gavyn Davies, Chairman of Fulcrum Asset Management, announced his firm is about to launch a hedge fund replicator called Fulcrum Alternative Beta Plus.
20% gross or 14% for 9% net
Alternative Beta offers an "efficient fee structure to investors", as well transparency, but not alpha generation. Davis showed that with the accumulation of fees (2+20, 3% transaction costs and 1% costs for "netting off" different parts / submanagers etc.) , a portfolio has to achieve a 20% return so that a 9% yield is produced for the investor. He said an alternative beta portfolio would only have to achieve a 14% gross return, which then gets reduced by 3% transaction cost and a 2% alternative beta fee to the same 9% yield.
We've been through this before
Davis said that the asset management industry has "lived through this before" when in the 90'ies indexation and passive investing (e.g. in the mutual fund world) massively change the way assets were run. In our days however, Davis concedes the replication is "much harder to do" in hedge funds than going passive on the S & P 500.
The Fulcrum Alternative Beta Plus ("FAB") combines active trading with a risk stream approach. The active trading component trades about 130 assets based on algorithms, goes long and short etc. Davis said there are two main approaches for obtaining alternative beta in a passive manner, one being the regression approach, which uses rolling regressions over past 24 months against a small number of simple risk streams. Results are used to form a portfolio of risk streams for the month ahead.
The risk stream approach on the other side does not attempt to replicate returns on a month by month basis, but attempts to produce a similar or better pattern of returns and risk than hedge funds over a period of quarters. The risk streams used in this approach are usually greater in number than in the regression approach, and are often far more complex, allowing to build models that "are quite close to what hedge funds do in practice."
Davis says models combining the risk stream and the regression approach can come short, as both approaches display a fairly high correlation. FAB finds the combination of active trading with risk stream more rewarding. In 2007, the FAB produced 5.5 % YTD including August. Backtest return statistics indicated 15.1% net annual return at 7.4% annual volatility and 1.48 Sharpe. The system "works because of the relatively dynamic changes of the equity weightings of the portfolio."
It took Fulcrum "a couple of years" to develop the program. It is intended "to match or improve on hedge fund returns on 12 - 24 months basis", and not to replicate hedge fund returns exactly on monthly basis.
Room for Alternative Beta and hedge FoFs
Besides, referring to Bill Fung who showed that hedge funds "aren't great vehicles in meltdowns" - why replicate then when they fall of a cliff, asked Davis. For Fulcrum, "exact hedge fund replication" would not be critical.
Comparing advantages and disadvantages of an alternative beta product versus the FoF approach, Davis said that alpha generation is not necessarily intended for the FAB and "questionable" for FoFs. Alternative Beta of course would provide liquidity, fee advantages and transparency. FoFs on the other side may beat Alternative Beta products in diversification aspects - "even if the FAB invests in 130 assets, you still have one product". Additionally, a good FoF with an experienced and well equipped team may have an an "innovation edge" when it comes to a quick adaption to changing macro parameters or capturing new opportunities. Davis thinks there's room for both vehicles, and "there is no reason to assume that any of these approaches will become so dominant that it will knock out all of the others."
Fulcrum Asset Management LLP was founded by Gavyn Davies and Andrew Stevens in 2004. The firm has a team of 23 who mostly have worked with each other at Goldman Sachs Investment Management.
Hossein B. Kazemi`s White Bear `momentum-matching` hedge fund replicator
Hossein B. Kazemi, Managing Partner of Alternative Investment Analytics and Professor of Finance at the University of Massachusetts, introduced a replication model that went live in May 2007. Until about July 25th, his White Bear Partners WBP Equity L/S sort of tracked the S & P 500 and the HFRX, however since that date and until August 22nd, his system held up by a significant margin.
Kazemi said two methods were prevalent for "completing financial markets": 1. Lots of trading (Black.-Scholes) or lots of assets (Arrow-Debreu). Kazemi says that "in a sense Kat and Palaro use the frequent trading approach to complete markets and to replicate hedge fund payoffs. We argue that using "lots of assets", the same goal can be approached by lower costs and higher correlation with the target.
The following are the pillars of this "momentum matching" strategy:
A large set of asset classes is initially considered for investment. Currently, over 30 equity, fixed income and commodity investments are considered.
A Multivariate GARCH model is used to estimate the variance-covariance matrix of these asset classes assets periodically
The estimated variance-covariance matrix is used the select the most useful asset classes in replicating the benchmark (by reducing the number of assets to 8 to 15) and to estimate optimal weights.
Other market factors such as credit spreads, term spread and volatility are used to adjust weights between calibration periods. this allows the model to react on a daily basis to change in the market conditions.
His model also delivers interesting insights how through time the different asset classes become important in explaining the return to hedged equity strategy, underlining its momentum-centric characteristics.
In a side note, Kazemi said it may be possible at some point in the future that hedge fund managers may outsmart factor based models, using the models as liquidity providers.
Soehnholz: The contrarian view
Dr. Dirk Soehnholz, Managing Director FERI Institutional Advisors, voiced a contrarian view, doubting if replicators can really outperform "good investable hedge fund indices". True to the saying "I've never seen a bad backtest", Soehnholz doubted the value of backtest series often presented by replicators. He also pointed out that once the replicator operates in real time, some of them reach a correlation of 0.8 to the MSCI World index, therefore highly questioning their diversification benefits and "downside protection". FERI sponsors an investable hedge fund index, which according to Soehnholz displays a lower volatility and even more attractive "after all fee" costs compared to available replicators.
"Suppliers of 130/30 and replication products have to show that they are not just hte next bad hedge fund with a limited investment universe and inexperienced management (130/30) or passive approaches to the complex world of hedge funds. In contrast, some investable hedge fund indices have already shown that they are attractive for more than five years and therefore also in difficult market conditions." In a side note, Soehnholz mentioned his firm has identified over 220 different factors which influence hedge fund returns, and the list keeps growing.
Beckers: Don't add another flawed investment option
Stan Beckers, Head of Alpha Management Group, Barclays Global Investors goes even further. The root problem of all is that most hedge fund managers would not provide "true alpha", so why bother and create another plethora of flawed investment options.
Fung says it's really about "leaving the the people who can produce true alpha doing their job, but to "mechanise" the beta aspects of performance and drastically lower investment fees."
Harry Kat: Why replicate if you can create?
Kat defines Hedge fund replication as "designing mechanical trading strategies in traditional assets that generate hedgefund-like returns." Further, hedge-fund like returns can be understood either as as a strict replication - the same returns month-to-month, whereas weak replication would mean same return properties. Kat's FundCreator approach is designed as a weak replication.
This can be done by either "creation" in a significantly different way than a hedge fund operates, or by "imitation" (acting similar to an hedge fund).
Most hedge fund replication attempts so far have been aimed at hedge fund index replication, and strict hedge fund replication has not been achieved so far, according to Kat.
Kat admits the alpha of synthetic funds comes from reduced costs, improved liquidity etc., not from superior investment skills. It would not be possible to replicate superior skills.
Kat mentioned in a side note that since his FundCreator went live some two years ago, some clients are not using the method to achieve returns but to change or optimize their risk/return profile. As the system is dynamic and diverse statistical properties can be defined as target parameters, it offers a hedge fund of fund or even single hedge fund a proven method to smoothen and optimize its own risk profile and volatility by adding a synthetic overlays.
Another interesting aspect of the system is that Kat says it is possible to replicate a certain hedge fund after having fed the FundCreator with its statistical properties, FundCreator will be possible to continue to trade even if the "underlying" hedge fund decides to either stop trading and goes cash or change the strategy when the (fundamental) opportunity set for the hedge fund (for example arbitrage) has vanished.
HEC replicates Kat!
Dr. Nicolas Papageorgiou said the HEC University in Montreal has developed, together with Desjardins Global Asset Management, a synthetic futures trading model similar to Harry Kat's model. Papageorgiou believes that such an approach to create synthetic funds is highly feasible. No online Source
Here are a few more tidbits from the Hotel President Wilson here in Geneva…
“I’m thinking about launching an index fund of replicated hedge fund index funds!”
- John Godden, IGS Group, jokes about a fund of funds to replicate the replicators
“Alternative beta is like sex in high school. Everyone talks about it, but no one is actually doing it. Well we have had sex…and we don’t pay for it…In fact, sometimes we get paid!”
- Peter Norman, AP7 Pension Plan on his policy of investing in low-cost alternative beta and often generating revenue by lending equities.
“We call it Virgin Beta…It’s just a wording.”
- Mikael Simonsen, Ice Capital, on a new form of beta somewhere between alpha and alternative beta.
“I live for rare events.”
“You simply can’t ignore extreme events. For example, if you remove 2 hours out of O.J. Simpson’s life, he’s a perfect citizen.”
“Standard deviation is not a concept that is workable in finance.”
- Nassim Nicholas Taleb, risk expert and best-selling author on non-normal distributions
“We weren’t that enthused about it.”
- Neil Simons, Northwater Capital, on the correlation-targeting aspects of distributional replication
“Hedge fund replication will drive a normalization of hedge fund fees.”
- Gianluca Oderda, Pictet Asset Management on the impact of hedge fund replicas
Alpha Male has attended more hedge fund conferences than he cares to remember. Many of them have begun with several empty seats and ended with far more. But apparently the good citizens of Geneva know a hot financial topic when they see one. You know all those seats along the back wall for late comers? All packed. You know the aisle - where you walk - to get to your seat? Also packed (with extra chairs that had to be brought in). The main conference hall of the Hotel “President Wilson” in Geneva was overflowing yesterday morning as Professor Bill Fung of the London Business School kicked off this two-day gabfest on hedge fund replication. Thankfully, it appears the Geneva fire marshal must have been off having a chocolate eclair at some swanky cafe by the lake.
Why all the interest? Hedge fund replication - that esoteric and highly quantitative discipline that had struggled for attention only a year ago - has suddenly hit the mainstream.
But rather than freaking out about it, it seems that many hedge fund operators have embraced the old enemy and have positioned hedge fund clones as a complement, not a substitute, to traditional hedge funds. For example, Fung himself told the audience:
“Hedge fund replication is here to supplement existing hedge fund strategies by providing greater liquidity and transparency.”
As a result, many (actually most) of the speakers yesterday came armed with their own offerings. We found nothing inherently wrong with this. But it did make me long for the days when a small minority of speakers pitched their wares while the majority just wanted to share some cool research about the behavior of hedge funds. But I guess that’s what they mean by the “institutionalization” of the hedge fund business.
There was a lot of talk about hedge fund indexes, even though the event was not actually about that topic. In fact, speakers seemed to jump seamlessly between hedge fund replication models and hedge fund indexes - as if the two were synonymous.
And I guess they are synonymous to those who are in the replication business to produce alternatives to existing hedge fund indexes (e.g. JP Morgan). But to many (e.g. Fulcrum Asset Management), hedge fund replication is more than a tool to match the average hedge fund return - it’s a tool to produce alpha.
But for those who aimed to simply represent the average returns of hedge funds, the question then became: which index are you trying to clone? Several speakers pointed out that the difference between different hedge fund indexes could be as much 4% per annum. So a passive hedge fund replication technique with a high correlation to one of the hedge fund indexes might also have a relatively low correlation to another of the major hedge fund indexes.
Hedge Fung Replication
Fung believes that the reason hedge funds exhibit such a high correlation in times of distress (e.g. August, for some strategies) is not because they share the same assets, but because they share the same liabilities. In other words, Fung says “they all borrow from the same investment banks”.
Ergo, says Fung, any successful hedge fund replication model must integrate elements of the hedge fund industry’s liabilities, not just their assets.
Fung also presented several interesting slides showing the performance of the major hedge fund clones over the summer. We’ll try to wangle those from him tomorrow. But the bottom line is that after a pretty good first half, most lost a tiny bit in June, a bit more in July and even more in August (although they recovered from an average drawdown of several percent at mid-month).
“No Desire to Replicate the Downside”
Gavyn Davies, former head honcho at the BBC, Goldman Sachs banker, columnist for the Guardian newspaper and the founder of Fulcrum was one of the attendees that expressed no desire to fully replicate the average hedge fund. Taking a more active and liberal view of the term “replication”, Davies illustrated to the audience how his “risk stream” and “active trading” approach blew the pants off the traditional hedge fund indexes.
Davies also had some choice words for funds of funds. According to his research, it would take a fund of hedge funds about a 20% gross return to produce the same net return as a passive replication product with a 14% gross return (mainly due to the lower fees of most clones).
On the other hand, argued Davies, factor replication models “have trouble with market turning points” since they generally look back 24 months or more to calculate the appropriate factor weightings for the next month. Therefore, when the tech bubble blew up, (back-tested) factors models didn’t clue-in to the fact for over a year.
In contrast, he says, his “Fulcrum Alternative Beta Plus” (FAB-Plus) model reacted much quicker to such events and therefore had a much lower market correlation than many factor models.
Still, Davies echoed Fung when he told the audience that alternative beta funds and real funds of funds “will both have a big future”.
JP Morgan Stanley
The Fung & Hsieh-advised JP Morgan Alternative Beta Index (ABI) then went head to head against Morgan Stanley’s new “Altera” offering (Alt-era. Get it?). Both funds were given a performance-agnostic spin. JP Morgan’s Lakshmi Seshadri and Morgan Stanley’s Yazid Sharaiha both emphasized that their objective was to mimic the hedge fund universe, not to beat it. Sharaiha said his idea of a great hedge fund replication model was one that worked “out of sample” (i.e. one that actually explains hedge fund returns in different time periods). And Seshadri said that the “alpha-centric” industry needed an objective benchmark.
A Natural Extension
Philippe Schenk of Credit Suisse Tremont Index LLC rounded out the morning by proposing that “replication is a natural extension of the index business”. But he also asked why anyone would want to develop another product when most already produce much of the alternative beta embedded within investable hedge fund indexes.
In answering his own question, Schenk said that “now we can focus on trying to replicate the (better performing) non-investable hedge fund indexes.”
The Contrary View
Just when everyone - funds of funds and clones alike - were starting to get along, the afternoon speakers rocked the boat.
Dirk Sohnholz of FERI Institutional Advisors teed things up by accusing providers of hedge fund clones of cherry-picking the benchmarks that made their products look best (whether or not the clone’s objective was to beat or simply match the indexes). Reflecting a modest level of cynicism, Sohnholz told the audience that “marketing-wide, hedge fund replication is a great story.”
But if Sohnholz teed it up, BGI’s Stan Beckers hit the 400 yard drive - landing it right between the eyes of the hedge fund replicators gathered in front of him. In a blunt tirade that some in the audience actually admitted was refreshing in its candor, Beckers railed against any form of hedge fund replication and predicted the industry would all but disappear in 5 years. He saved his best barbs for the hedge fund indexes that replicators aimed to mimic, complaining that the industry was “targeting an illusionary, flawed and poor reflection of the hedge fund universe.”
Fung agreed and raised questions of his own about the accuracy of hedge fund indexes. However, the CISDM’s Hossein Kazemi (who ran such a database) said his research indicated that hedge fund indexes were actually pretty accurate reflections of the hedge fund universe after all. An audience member - I think it was Deutsche Bank’s Tony Chapple - told Beckers that the problem of the missing mega-funds was essentially solved by mimicking a fund of funds index since such an index would essentially reflect the performance of the world’s largest (non-reporting funds) via the funds of funds in their databases.
Flying Dutchman Fights Back
Harry Kat, the human lightning rod for strong opinions on this topic, then addressed the gathering and responded to “10 Unjustified Criticisms of FundCreator” (his distributional replication tool). We’ll leave the details for a future posting. But suffice to say, the panel had mixed feelings about Kat. At one end of the spectrum, Fung continued to attack things such as the model’s reliance on monthly data to make daily trades and the fact that an investor might have to wait 2 years or more to find out if FundCreator was actually working properly.
At the other end of the spectrum was Nicolas Papageorgiou of HEC Montreal Business School. Papageorgiou studied under Kat and along with his client, Canadian giant Desjardins Global Asset Management, he is a proponent of distributional replication (you may recall his paper on the topic).
In the middle were Kazemi and author Nassim Nicholas Taleb (speaking tomorrow) who both expressed reservations about distributional replication, but never really took a swipe at the Kat.
And that’s how things ended up on day one. With impassioned opinions, colourful debate and not an empty seat in the house.
Heard on the floor at Terrapinn’s “Hedge Fund Replication & Alternative Beta” conference in Geneva so far today…
“His trading process may be “naive”, but his fees sure aren’t!”
- Professor Harry Kat on the hedge fund replication strategy pursued by another well-known firm.
“The asset information submitted to any of the databases is absolutely useless. How many of the biggest hedge funds in the world actually provide an information to any database? BGI, one of the world’s largest hedge fund managers, does not submit its data to any of the hedge fund indexes.”
“Five years from now, all hedge fund replicators will be out of business. We’ll all look back and think ‘what a silly idea that was’!”
- Stan Beckers, Head of Alpha Management, BGI on hedge fund databases and hedge fund cloning in general
“Tom Schneeweis and I published our own hedge fund replication results on our website 6 years ago. But we only got 2 phone calls…No one cared…so eventually we stopped doing it. Apparently we should have continued.”
- Hossein Kazemi, Center for International Securities and Derivatives Markets (CISDM), jokes about his sense of timing in front of an overflow conference audience
A Beta Way To Boost HF Returns, From InsitutionalInvestor.com, 21/9/7
The secret ingredient to boosting performance of a hedge fund portfolio is some alternative beta, according to Stonebrook Capital Management. In fact, a first-of-its-kind study conducted for the New York-based firm that specializes in AB, says 30% is about the right mix. Based on 14 years of backtesting, the research found that the optimized portfolio containing AB generated annualized returns of 11.2% with a 3.53% standard deviation. In contrast, Hedge Fund Research’s HFRI Fund of Fund Index clocked in at 9.13% per year with a standard deviation of 5.56%. Says Jerome Abernathy, Stonebrook’s chief investment officer, who co-authored the study with Ahmad Ajakh, the firm’s director of research. “The study shows that alternative beta represents an important tool in the construction of hedge fund portfolios,” adding that AB “materially improves the liquidity characteristics of the portfolio, enables investors to concentrate on identifying and investing in high alpha managers and reduces headline risk.” Stonebrook says it has recently launched an AB product in a fund format, said to be the first of its kind in the U.S. “Alternative beta is quickly gaining acceptance as a liquid-efficient means to achieve the risk and return characteristic over the overall hedge fund industry,” notes Ajakh.
State Street Quietly Launches Hedge Fund Clone, HEDGEWORLD 18 September 2008
BOSTON (HedgeWorld.com)—State Street Global Advisors is the latest asset manager to launch a hedge fund replicator, following close on the heels of such firms as Goldman Sachs, Barclays and, most recently, Morgan Stanley. The new product has been running since July with seed capital from SSgA. The asset manager has to-date taken a low-profile approach in marketing the product to clients as it develops a track record.
The new clone uses a factor-based approach to identify the return drivers of various strategies. The objective is to "identify beta factors that have high explanatory characteristics with respect to HF returns," Paul Brakke, head of SSgA's global structured product group, told HedgeWorld on Tuesday [Sept. 18]. The approach is similar to that used in alternative beta products from Swiss asset manager Partners Group and AlphaSwiss, as well as to the Alternative Beta Index proposed by JP Morgan Previous HedgeWorld Story.
Not surprisingly, since SSgA's replicator has been developed, Bill Fung, David Hsieh and Narayan Naik have been working together on it. The three are among the best-known researchers into hedge fund returns and their drivers, and their research also underlies JP Morgan's Alternative Beta Index and replicator products based on it. Mr. Fung is currently visiting research professor of finance at the BNP Paribas Hedge Fund Centre at the London Business School, where Mr. Naik is professor of finance and director of the BNP center. Mr. Hsieh is Bank of America Professor of Finance in North Carolina's Duke University.
"Bill and I have been working on identifying the components of hedge fund returns for 10 years," said Mr. Hsieh in a conversation with HedgeWorld earlier this month. "Our model is factor-based in that we have tried to understand the core trading strategies in each hedge fund style and to reproduce them. The instruments that we use vary across the strategies." He said the main question the pair needed to address was: What instruments can reproduce returns that look like the ones they have observed?
"The general philosophy is that if you have a set of managers, you want to model what is common between them," said Mr. Fung. "You are trying to capture underlying common strategy." Replication is not about replicating the manager, he explained. "They change with market events and opportunities—their emphasis shifts over time in accordance with the markets, and it's difficult to follow single shifts in the way risk capital is being used."
In short, if managers stop doing what they do well, returns will suffer. "It is therefore a mistake to try to model manager by manager, since you expect them to change," he said.
With some strategies such as commodity trading advisers or managed futures, the pair observed, returns look similar to those on look-back options, in effect pairs of structured options, which Messrs. Fung, Hsieh and Naik have studied extensively.
"We're tracking general trends," Mr. Hsieh said. "By the time a typical manager reacts to a change, we have plenty of time to pick it up in model. We're tying to capture what managers are doing, we're not trying to predict what they're going to do. We tend to be reactive, so the model may be accused of being slow, but it is accurate."
But if the reaction of the model is slow, how does it protect itself from something like the blowup in many directional strategies seen in August when volatility suddenly spiked? After all, particularly in hedge fund land where there tend to be a large number of leveraged bets, the impact of adverse events on performance can be extremely quick, while the reallocation of assets is generally a lot slower.
"What got interesting [in early August] was that so called non-directional strategies began to demonstrate characteristics similar to an insurance-type of risk exposure, in line with the old adage that at bad times things tend to converge," said Mr. Fung. "With our model, in a very subtle way seemingly non-directional strategies do show up. They have extreme tail risk exposure to liquidity risk, which does show up in our model."
Mr. Brakke noted that look-back options also come into play in these circumstances. "Look-back straddles are used to pick up non-linearity obtained from hedge fund returns," he explained. "They provide investors with some degree of tail insurance."
Further, noted Mr. Hsieh, the risk management of the portfolio is guided by the decisions made by the individual investor, "so their asset allocation tells us where they want concentrated risks and where they don't." Mr. Fung added: "The long gamma positions achieved through look-back straddles help to ensure they don't get destroyed if extreme tail risks should materialize."
One thing the SSgA replicator won't be doing is looking to capture liquidity premiums. "It's hard to capture a liquidity premium when you're using liquid securities," said Mr. Fung. "Moreover, the cost of managing and executing this kind of position is much higher than for a more passive replicator, and ends up being just as expensive and opaque as a normal hedge fund."
"If someone could replicate the performance of illiquid securities, they'd have launched a product on the market by now," added Mr. Hsieh.
"Our model is slightly different from JP Morgan's Alternative Beta Index," Mr. Brakke explained. "The factors are pretty much the same, but the asset being used to replicate the factor can be different. If you want a particular type of yield curve exposure you will choose the most appropriate tools in accordance with the client's situation." While JP Morgan has constructed its index to best capture the returns of alternative beta, SSgA has taken a more dynamic approach by considering the client's existing portfolio and the cost-effectiveness associated with adopting a different strategy.
Mr. Brakke said the generic version of the product would probably cost clients about 60 basis points in fees, though costs would be higher for clients requiring a more customized solution.
T-Rex (Total Return Exposure) strategy to synthetically replicate synthetically HFR Index performance From Structured Products Online.com: 7 August 2007
SGAM AI’s new Ucits fund replicates hedge funds
SGAM Alternative Investments (SGAM AI) has launched a Ucits-III compliant mutual fund using the concept of the T-Rex (Total Return Exposure) strategy, which replicates synthetically the performance of the Hedge Funds Research (HFR) Index. This is achieved with a managed portfolio of liquid financial instruments such as futures on the major assets, including equities, bonds and currencies.
The allocation process of the fund is based on a quantitative model, created by SGAM AI’s structured asset management team. The model calculates the allocation that offers a high correlation to the performance of more than 2000 hedge funds tracked in the HFR database without the subjective input of a fund manager. In order to maintain this high degree of correlation, positions are re-weighted every month.
The Ucits-III compliant fund offers daily liquidity and transparency as the portfolio allocation will be published continuously on the SGAM AI’s websites. Other than retail investors, the fund aims to attract asset managers and private banks that are looking for an underlying for structured products.
Morgan Stanley announces altera, an improved platform for alternative investment replication strategies From Opalesque, 26 July 2007
Morgan Stanley announced today the launch of altera, a new investment platform that will give investors access to ‘alternative beta’ strategies through mutual funds or customized contracts. altera will draw on the intellectual capital from many areas of the Firm. This product will give our clients access to Morgan Stanley’s best trading strategies across asset classes and allow them to benefit from the multiple sources of quantitative and derivative expertise we have available,” said Kevin Woodruff, Head of North America Equity Derivatives. Offering key innovations compared to first-generation hedge fund replication products, altera aims to achieve industry-leading performance. “Our objective is to match the performance of a leading benchmark hedge fund index,” said Yazid Sharaiha, Global Head of Quantitative and Derivative Strategies. “In backtests, the altera model achieves this performance objective while at the same time offering improved liquidity, controlled turnover and more transparency than an actual hedge fund.” Morgan Stanley’s altera improves upon first generation products by using tailor made, high performance investment strategies. Backtests demonstrated that altera’s choice of strategies improved hypothetical returns when compared to those used by existing products. Another altera innovation is an advanced quantitative methodology that both increases returns and reduces risk compared with existing products. According to Patrick McAllister, Head of North America Quantitative Equity Product Origination, “altera’s methodology is especially valuable around market turning points, offering the possibility of better results than first-generation products at these critical times.” Morgan Stanley plans ongoing research and continuous improvement in quantitative methods for altera. Another differentiating factor is altera’s use of MSCI’s Hedge Fund Indices as benchmarks. The MSCI Hedge Fund Indices facilitate detailed performance measurement and attribution due to their flexible design and use of MSCI's granular Classification Standard for categorizing hedge funds. Furthermore, Morgan Stanley plans to extend altera to cover selected single strategy indices in the future in addition to the composite.
Move to mimic hedge fund glory: From FT, June 18 2007, By Deborah Brewster in London
Why pay a 20 per cent performance fee for a hedge fund when you can replicate one for almost nothing? A slew of products using computer models to clone or replicate hedge fund returns are being launched in a bid to capture some of the billions of dollars flowing into the industry.
The products have the potential to revolutionise the industry, in much the same way as indexed funds affected mutual funds.
New York-based Stonebrook Capital is the latest to launch what it calls an “alternative beta” strategy, using models to replicate hedge fund strategies. It charges a 1.5 per cent management fee instead of the 2 per cent management fee and 20 per cent performance fee typical of actual hedge funds. The firm is also one of few African-American owned hedge fund groups, an advantage given pension fund pressure to allocate business to minority-owned firms.
Jerome Abernathy, the founder of Stonebrook, said research shows 70 per cent of gross hedge fund returns could be attributed to market returns rather than the skill of individual managers. Also, more than 30 per cent of gross returns went to the hedge fund manager in the form of fees.
Goldman Sachs, Lynch and Bank have launched hedge fund replica strategies, available to institutional investors. JPMorgan will launch one in the next few weeks, in a tie-up with three academics who produced the definitive research showing that hedge fund returns could be duplicated by computer models. IndexIQ, a New York-based quantitative strategist, has launched a series of synthetic indices which it is offering to distributors.
Rydex Investments, which services retail investors, was the first to launch such products. It has attracted $500m in the past 18 months to its three funds, which replicate hedge fund strategies but are structured in the form of mutual funds. It launched a replica managed futures fund two months ago, which has already pulled in $140m in retail money.
Patrick DiNuzzo, an investment adviser, said: “We have been dying for this type of solution for years... they are at the leading edge of enormous demand in the marketplace.”
Rydex plans several more replicas, based on merger arbitrage and currency strategies. The returns of its main fund so far have slightly underperformed most indices.
The products offer average hedge fund returns, not the outstanding returns that some individual managers do. However, the risk of a diversified portfolio is less. And they charge less than either a single fund or a fund of funds, the previous method of getting diverse hedge fund exposure.
Investable hedge fund indices, launched a few years ago, have not caught on because they do not include funds closed to new investors, cannot properly replicate the hedge fund industry, and tend to underperform. The synthetic indices and funds have no such hurdles because they do not include actual funds, but analyse typical strategies then recreate them.
Copyright The Financial Times Limited 2007
All about Alpha, 15 March 2007, Professor Harry Kat responds to EDHEC study on hedge fund replication
After yesterday’s story on EDHEC’s new hedge fund replication research, we were curious about Harry Kat’s take. With some cajoling by us, Professor Kat responds below…By: Prof. Harry Kat, Cass Business School, City University (London)
In a recent interview published at All About Alpha and a research paper presented at the Edhec Asset Management Days in Geneva on March 13, Edhec researchers make some statements with respect to the workings of and results that can be obtained from our “FundCreator” technology that could be misconstrued. In this note I hope to clarify a few important issues. But first, I’d like to start with a short story that will clearly illustrate the point that I’d like to make. “Leo” and “Chris” are walking down the High Street and suddenly notice this beautiful shiny new car. They stop to take a closer look. “What is it?” says Leo.
“I don’t know”, says Chris. “…never seen anything like it”.
“Hey, wait a minute”, Leo shouts, “It says ‘Rolls Royce’ over here”.
“That must be it then.” says Chris. “It’s the latest Roller. I think I read something about it in a car magazine in the supermarket last week”. After taking another good look, both wander off fantasizing about what it would be like to have a car like that themselves. Closer to home, Leo suggests they build a Rolls Royce for themselves. Chris agrees and offers his tools and his garage as a workshop. The two go to work and by the evening their car is finished. Indeed, it looks very much like the real thing. They both jump in and hit the road. Driving around the neighbourhood, however, it quickly becomes evident that the car they built looks a lot better than it drives. It’s bumpy, takes 20 seconds from 0 to 60, doesn’t steer properly and the brakes squeak. Of course, that’s not really surprising, as they only got to see the outside of the Rolls they were trying to replicate. And Rolls Royce has been refining the inside of the car for nearly 100 years. Disappointed, Leo and Chris return home to evaluate their efforts. What are Leo and Chris to conclude? Will they conclude from today’s experience that Rolls Royce doesn’t make good cars? No. Ultimately, Leo and Chris draw the only rational conclusion: that their attempt to build their own Rolls Royce was unsuccessful.
Now turning our attention back to FundCreator and the Edhec research, one could tell a very similar story. FundCreator’s roots go back more than 7 years. Over that period, more than 10 man-years have been invested in developing the various procedures and the system itself. Packed with state-of-the-art estimation, optimisation and stochastic control routines, the FundCreator C++ code currently spans over 17,000 lines. Nobody can realistically expect to recreate this in the comfort of their own garage. Indeed, with the help of our November 2005 research paper one could build something that looks like FundCreator on the outside, but since it is difficult to surmise what really goes on inside the machine, one should not expect the same results. In other words, and in my view, EDHEC researchers simply did not accurately replicate FundCreator. Apart from not accurately replicating FundCreator, the Edhec researchers may have misinterpreted some of the published results. In the aforementioned interview, for example, EDHEC says, “Using the S&P 500 index as the reserve asset (as Kat does), our replications under-perform systematically and significantly, by approximately 500 bps per year.”
However, in FundCreator, the reserve asset is not simply the S&P 500 index. Since the reserve asset is at the core of every FundCreator strategy, it should contain as little uncompensated risk as possible. We therefore advise everybody using the system to use a well-diversified basket as the reserve asset, not just one single index. In our own research we use a portfolio of Eurodollar, 5-year and 10-year note, Russell 2000, S&P 500 and GSCI or crude oil futures. Apart from leaving a lot of diversifiable risk, using only the S&P 500 as the reserve asset will pull in the full 2000-2003 equity bear market. It is therefore not at all surprising that the Edhec study finds the strategy underperforms significantly - it is significantly under-diversified.
So how can one evaluate something of which one doesn’t know what is going on inside? I think that’s simple - try it out and examine the results themselves rather than the methodology. We have never held back information about the results achievable with FundCreator. On the contrary, we have published a whole variety of back tests, on the FundCreator website (and elsewhere) going back to 1995. In my view, these back tests show one thing very clearly: FundCreator is efficient and remarkably robust with respect to transaction costs, the rebalancing frequency, the choice of reserve asset, etc.
“The proof of the pudding is in the eating” Don Quixote once said, and he was 100% right.
Place Your Bets: Investible Indices vs. Replication Strategies
Albourne Village / Global Pensions, March 12
Pension fund demand for hedge fund indices is minimal and the advent of replicator funds could deal a death blow to them, some of the world’s largest consultants have claimed.But FTSE Group alternatives business unit head Gareth Parker insisted passive indices would play “a very big role” in the hedge fund market going forward.He claimed some of the consultants’ scepticism was due to “an educational issue”, and also questioned the threat replicator funds could pose to their market share. “How do they know what they are replicating?” he asked. “Hedge funds – especially the good ones – are very secretive about what they are doing, so a replication fund will only be able to find out what they were doing a month ago when they release a report, but obviously you are then way behind the market.“Some 20% of the institutional equity money in UK is entirely passively invested. I am convinced that as the hedge fund market matures, there will be a very big role for passive indexes.”Mercer Investment Consulting principal Robert Howie said demand for hedge fund indices had been low among the firm’s clients and added the firm had generally steered clients away from them.“Investible indices are touted as passive investments, but the underlying managers don’t discount their fees, and to me that is illogical and contradictory. The whole point of index tracking is that you get it really cheaply, and that is simply not the case with investible indices.”He added replication strategies would probably be the future of passive investment in hedge funds.Watson Wyatt senior consultant Chris Mansi agreed. “The indices also can’t seem to access a better quality collection of hedge funds. They are not the most attractive sort of capital for high quality hedge funds,” he said.Wilshire Associates VP Paul von Steenburg said although uptake of such indices had been slow, some were “pretty hard to beat” on a risk-adjusted basis.“Each index provider does it completely differently, so some might not be appropriate at all, but others have better construction methodology.
Deutsche Bank unveils low-fee hedge FoF `beta replication index`
The db Absolute Return ßeta Index uses a proprietary algorithm to invest long and short across a variety of asset classes. According to Deutsche Bank, the product improves on existing investable replication indices by replicating returns before fees.
“It is a natural evolution of a maturing hedge fund industry that beta products will be introduced to complement active alpha managers,” global head of fund derivatives Stephane Farouze said. “I believe that the db Absolute Return ßeta Index is superior to the other hedge fund replication products due to its unique construction methodology in adding back to the hedge fund fee structure, and as a result its superior performance.”
Deutsche Bank said dbARß can be accessed via UCITS III Funds, certificates and notes in a number of different formats.
Merrill Lynch today introduced ML FX Clone, a methodology for replicating hedge funds' foreign exchange (FX)
strategies that will help investors to better understand and ultimately access the FX markets with greater ease and at lower cost. ML FX Clone is designed to replicate the most widely-used FX investment styles followed by active portfolio managers. Merrill Lynch research analysts have designed ML FX Clone for investors who wish to gain exposure to FX as an asset class or who wish to hedge underlying exposure to currency funds. ML FX Clone also helps investors to separate manager alpha - how much the portfolio manager contributes to returns - from beta - how much market factors contribute to returns. "Our replication strategies offer attractive returns and diversification benefits similar to those of broad currency portfolio manager indices," said Alex Patelis, head of global foreign exchange and local currency strategy at Merrill Lynch. "However they are more transparent, have greater liquidity, little manager risk, and have potentially lower trading and transaction costs."
Replicating Three Strategies: Momentum, Carry Trade and U.S. Dollar
ML FX Clone was developed to help make foreign exchange a more accessible asset class by providing more information and insight on the three investment strategies that FX portfolio managers most commonly use. The first strategy is momentum, in which a portfolio manager identifies and follows market trends. The second strategy is the carry trade technique, in which investors buy currencies from economies with higher interest rates and sell those from economies with lower interest rates. The third strategy is the U.S. dollar method, in which investors take a view on a currency relative to the value of the U.S. dollar. Merrill Lynch analysts have established a high correlation between the ML FX Clone model and existing benchmark currency market indices, including the Parker FX index. This indicates that the process can capture much of the variability in the returns achieved by different portfolio managers. Backtesting analysis shows that ML FX CLONE achieved an average annual return of 9.1% with a 0.82 Sharpe ratio -with only one year of negative returns since 1989 -, compared to 9.0% and 0.94, respectively, for the Parker FX index. Over the past three years, ML FX CLONE has mirrored the underperformance of the Parker FX index.
Merrill Lynch analysts noted in an October 2006 report, "Replicating Hedge Fund Returns, New Alternatives in Hedge Fund Investing," that as the hedge fund industry matures and more active managers share and compete for available returns, justifying paying higher fees for active management may be increasingly difficult if similar strategies can be mechanically implemented at lower cost.
Deutsche Bank unveils low-fee hedge FoF `beta replication index`
From Finalternatives.com: Deutsche Bank has launched a new beta replication index that seeks to produce fund-of-hedge-fund-like returns without the high fees. The db Absolute Return ßeta Index uses a proprietary algorithm to invest long and short across a variety of asset classes. According to Deutsche Bank, the product improves on existing investable replication indices by replicating returns before fees.
“It is a natural evolution of a maturing hedge fund industry that beta products will be introduced to complement active alpha managers,” global head of fund derivatives Stephane Farouze said. “I believe that the db Absolute Return ßeta Index is superior to the other hedge fund replication products due to its unique construction methodology in adding back to the hedge fund fee structure...
From Finalternatives.com, May 25, 2007
Deutsche Bank has launched a new beta replication index that seeks to produce fund-of-hedge-fund-like returns without the high fees.
