Consultants said top-down hedge replication strategies have gotten little traction from U.S. institutional investors, although some European institutions have begun to use the strategies (Pensions & Investments, March 17, 2008 and June 25, 2007). U.S. money managers offering hedge fund replication strategies include IndexIQ, Rye, N.Y.; State Street Global Advisors, Boston; Stonebrook Capital Management LLC, New York; and Hedge Fund Research Inc., Chicago.
Finance professor Andrew W. Lo said he finds it interesting that academia and industry are exploring hedge fund beta in parallel discussions. After reviewing AQR's paper, Mr. Lo said he is “quite sympathetic to AQR's idea of a bottom-up approach” and noted that “alpha is becoming much less of an issue and beta is becoming much more of a focus of both academic and industry discussions.” Mr. Lo is the Harris & Harris Group Professor at the Sloane School of Management at the Massachusetts Institute of Technology and director of the MIT Laboratory of Financial Engineering, Cambridge.
Mr. Lo, also chairman and chief scientific officer of AlphaSimplex Group LLC, a money manager in Cambridge, Mass., is developing a top-down hedge fund replication strategy that seeks to mimic the performance of individual managers within a hedge fund index.
In his paper, Mr. Berger analyzed the beta of merger arbitrage hedge fund managers. He wrote: “Just as stock betas can be created by looking at the performance of a broad universe of stocks, the beta for merger arbitrage can be created by looking at the performance of a broad pool of merger investments (long the target, short the acquirer). Importantly, this beta reflects the economic intuition behind the strategy and ... it also captures a meaningful part of the strategy's historical returns.”
AQR has prior experience in managing hedge fund beta through a convertible arbitrage and a merger arbitrage hedge fund beta strategy for institutional investors it launched in 2001 using the same bottom-up approach.
Mr. Berger said in the paper that AQR researchers believe most hedge fund strategies have beta that can be identified and replicated using a bottom-up approach and that those betas can be combined to create a diversified hedge fund portfolio. He noted that in back testing, the return of a diversified portfolio of 10 hedge fund betas proved to be more consistently positive long term, outperformed established hedge fund indexes and was uncorrelated to traditional market exposures.
AQR has expanded its hedge fund beta strategy to include other hedge fund strategies and plans a September roll-out of the Dynamic Economically Intuitive Liquid Transparency Alternative strategy. The strategy consists of a series of investible hedge fund style indexes and subindexes that institutional investors can invest in individually or via a diversified multistrategy approach managed by AQR.
David Kabiller, a founding principal who has oversight of AQR's institutional marketing unit, declined to comment on the specifics of the strategy, citing Securities and Exchange Commission restrictions on private placement investments.
However, a source with knowledge of the approach who asked for anonymity said it will offer investors a significant degree of transparency with regard to investment process and positions. He said AQR's capacity for the product is about $10 billion.
AQR is offering the strategy with either a fixed or a performance fee, which will vary with the level of customization and volatility. Fees for a $25 million minimum investment range from a fixed fee of 75 basis points for a low volatility strategy to 150 basis points for a high volatility strategy. The performance fees will range from 40 basis points and an 8% performance fee for a low volatility strategy to 80 basis points and an 8% performance fee for a high volatility approach, according to the source.
Consultant Keith Black, associate and senior member of the opportunistic strategies investment management research group at Ennis Knupp + Associates Inc., Chicago, said he finds hedge fund replication strategies using top-down style analysis “to be uninteresting when implemented using ETFs, etc. All of the return, then, is from easily accessible betas. Of course, you keep custody of the assets and pay low fees, but, by definition, the alpha is zero and diversification relative to traditional assets is less significant.”
Mr. Black said much of the alpha from hedge funds “comes from taking liquidity risk, complexity risk and event risk exposures. A (traditional hedge fund) replication strategy does not earn any of these risk premia. If a bottom-up strategy invests in specific securities that earn these risk premia, then I would expect it to outperform the returns offered by the top-down beta replicators.”