Hedge fund replication strategies offer cheaper option

The next big thing in hedge fund investment won't be a hedge fund: It will be a replica.

A growing number of institutional investors are considering a move into sophisticated, rules-based trading strategies that meet or beat hedge fund index returns — at a much lower cost.

Sources predict that interest in hedge fund replication — still nascent in the global institutional investor universe — is likely to account for 5% to 25% of total institutional investment in hedge funds over the next 10 years.

If the predication proves to be true, that would put between $13 billion at the low end and $63 billion at the high end up for grabs by hedge fund replicators in the U.S. alone (in current dollars).

That's good news for hedge fund replicators and even better news for institutional investors, who will be able to achieve similar returns to a multistrategy hedge fund, typically paying the manager a 1% to 2% management fee or a 15% performance fee.

Considering that hedge funds typically charge both a 1% to 2% management fee and a 15% to 20% performance fee, consultants said the savings from a replication strategy end up being an alternative alpha source for an investor's hedge fund portfolio.

Not everyone will be happy about hedge fund replication consuming an ever larger percentage of institutional hedge fund portfolios. “Hedge fund managers will fight this trend because it likely will be a game-changer, especially for those managers who claim to be producing alpha and aren't really doing so,” said Deepak B. Gurnani, managing director, chief investment officer and head of hedge funds at alternative investment manager Investcorp International Inc., New York.

Investcorp manages $4.6 billion in hedge funds of funds and an emerging manager seeding program but does not offer a replication strategy.

Right now, demand is exceeding supply for hedge fund replication strategies robust enough to attract institutional investors.

“There is tremendous interest in replication because of cost reduction and as a way to separate hedge fund alpha from hedge fund beta,” said Daniel Celeghin, partner, Casey, Quirk & Associates LLC, Darien, Conn., in an e-mail.

But CQA, a consultant to money managers, has not tried to forecast how much the hedge fund replication industry will grow because its researchers “see the big constraint being supply. There simply aren't enough high-quality offerings,” Mr. Celeghin said.

In fact, sources pointed to AQR Capital Management LLC, Greenwich, Conn., as the only money manager gathering significant institutional inflows into its hedge fund beta strategy — Dynamic Economically Intuitive Liquid Transparency Alternative — better known as DELTA (Pensions & Investments, Aug. 4, 2008).

Four years after its launch, DELTA now has $4.5 billion under management, about 95% of which is from 100 institutional investors, including the $108.9 billion Teacher Retirement System of Texas; the $7.7 billion Missouri State Employees' Retirement System; and the Oregon Investment Council, which runs the $57.9 billion Oregon Public Employees Retirement Fund.

The field of hedge fund replicators was much larger prior to the 2008 financial crash, when factor-based approaches were successfully capturing equity beta and attracted a few early movers among European pension funds.

But these statistical replication strategies, which used regression analysis to look backward for the factors to determine hedge fund strategy exposures, lost their appeal after the crash.

“They just didn't work,” said Gaurav Amin, partner and head of risk at alternative investment consultant Albourne Partners Ltd., London. “They were the easiest and cheapest way for managers to attempt to replicate hedge fund returns by grabbing the equity beta through investing in the same sectors single strategy hedge funds did.”

Casey Quirk's Mr. Celeghin agreed: “For the most part, regression-based products don't really `replicate' hedge funds strategies, and building a good trade-based or sampling-based strategy is not easy.”

Creating and managing a hedge fund replication strategy “is just as hard as running a hedge fund. The concept is simple and it doesn't take an Einstein to understand it: go long bonds and short equity. But rules-based replication essentially is a trading strategy and the success of the approach will come down to the excellence and efficiency of trading and how assets are deployed,” Albourne's Mr. Amin said.

The small universe of viable managers notwithstanding, sources said institutional investors are looking seriously at rules-based replication strategies.

How they use such strategies differs.

Most of AQR's institutional DELTA investors are in the core-satellite group, using replication strategies for a large core allocation and alpha-producing hedge funds for the balance, said Ronen Israel, principal and the senior portfolio manager who developed and runs the DELTA strategy.

“Many institutional investors have a limited research staff. Using a hedge fund beta strategy permits them to very efficiently build a core exposure to hedge fund strategies that are easily replicable. Then staff can spend time on finding strategies that are idiosyncratic, unique and not easily replicable,” said Mr. Israel.

Other institutions are using replication to provide short-term exposure while they are building their hedge fund portfolios or when moving assets between hedge fund managers, sources said.

Once such fund is the Austin-based Texas Teacher Retirement System, which likely is the largest user of hedge fund replication strategies to date.

As of June 30, $2.1 billion of the system's $9.3 billion hedge fund portfolio was invested in a combination of internally and externally managed hedge fund replication strategies. The breakdown between the internally managed portfolio and the fund's investment in AQR's DELTA strategy was not available.

TRS investment officials, including T. Britton Harris IV, chief investment officer, declined to be interviewed.

But with 80% of its total hedge fund portfolio invested with individual hedge fund managers, it's clear from a hedge fund report distributed at a Sept. 13 TRS investment committee meeting that the goal of the internally managed replication strategy is “to minimize trust risk while building out (the) portfolio.”

But “TRS is likely to always have some hedge fund replication strategy in place. Hedge fund replication strategies provide a valuable benchmark to compare managers to see if they are delivering beta, exotic (hedge fund) beta or alpha,” said system spokesman Howard J. Goldman in an e-mail.

Investment consultants are divided on the efficacy of hedge fund beta and replication strategies.

Cliffwater LLC, Marina del Rey, Calif., tracks replication strategies closely, but only recommends them to clients as a “placeholder” while hedge fund portfolios are being built out, said Stephen L. Nesbitt, CEO.

Aksia LLC, New York, on the other hand, has been assisting its institutional clients in finding replication strategies for the past couple years.

“Many institutional investors are extremely motivated by cutting high hedge fund fees. It's all about fees and replication strategies are a good, creative solution. They represent progress on the fees front,” said Jim Vos, CEO, principal and head of research at the specialist hedge fund consultant. n