Skip to main content
MENU
Subscribe
  • Subscribe
  • Account
  • LOGIN
  • Topics
    • Alternatives
    • Consultants
    • Coronavirus
    • Courts
    • Defined Contribution
    • ESG
    • ETFs
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Opinion
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Russia-Ukraine War
    • SECURE Act 2.0
    • Special Reports
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • Climate Change: The Inescapable Opportunity
    • Impact Investing
    • 2022 ESG Investing Conference
    • ESG Rated ETFs
  • Defined Contribution
    • Latest DC News
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • Trends in DC: Focus on Retirement Income
    • 2022 Defined Contribution East Conference
    • 2022 DC Investment Lineup Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Performance Data
    • P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
    • Future of Investments Research Series
    • Charts & Infographics
    • Polls
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
    • 2022 Innovation Investing Conference
    • 2022 Defined Contribution East Conference
    • 2022 ESG Investing Conference
    • 2022 DC Investment Lineup Conference
    • 2022 Alternatives Investing Conference
Breadcrumb
  1. Home
  2. ALTERNATIVES
June 03, 2014 01:00 AM

Hedge fund replication: Is it appropriate for you?

Peter Hecht, Evanston Capital Management
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print

    Hedge fund replication products are a classic example of financial innovation. They attempt to mimic the core risk and return properties of a subset of hedge fund strategies within an investment form with greater accessibility and perceived better terms: lower fees, greater liquidity and enhanced transparency. It's not surprising therefore, that replication has received a lot of attention from the investment community. However, while replication products are a “net-net” positive innovation, they are neither simple to understand, homogenous in form, nor appropriate in every situation.

    Top down, bottom up

    Replication products were introduced in the mid-2000s in the form of a top-down, backward looking, regression-based approach that recommended investing in a handful of capital market risk factors instead of the underlying hedge fund strategies. Given inherent weaknesses, including an often-lower average return and a high correlation with traditional stock and bond markets, the top-down method was not widely adopted.

    Hedge fund replication “2.0,” or “bottom-up” replication, started in the late 2000s, gaining most in popularity over the past few years. Unlike top down, the bottom-up approach starts by attempting to understand the underlying securities and trading patterns of various hedge fund strategies. If the cores of certain strategies have little-to-no discretion in what and how they trade, the bottom up approach “replicates” the strategy using a similar set of systematic trading rules. The rules address which securities to go long or short, how to weight the securities and how often to rebalance. Bottom-up products implement the trading rules using a similar set of underlying securities traded by the traditional hedge fund manager. In effect, the bottom-up product is akin to an actual hedge fund manager using a rules-based, quantitative approach to trading the underlying securities associated with a particular hedge fund strategy. Some classic examples are convertible arbitrage, merger arbitrage, quantitative equity market neutral, and systematic macro/managed futures/CTA.

    It's important to note that many hedge fund strategies, such as fundamental long/short equity, fundamental long/short credit, distressed and others, are too discretionary and/or illiquid to replicate a meaningful core with a set of trading rules. While long/short equity replicators are available, they are functionally a basket of two strategies: quantitative equity market neutral plus an equity derivative overlay providing partial market exposure. This is different from a discretionary, fundamental long/short equity strategy.

    Bottom-up replication vs. Traditional hedge fund manager

    For the subset of strategies prone to replication, bottom-up replication products should be considered alongside traditional hedge fund managers. The decision to go with a replicator will depend on your manager selection skill and short-term liquidity needs. When the expected value add from manager selection is low and/or short-term liquidity needs are high, a thoughtfully executed replication product becomes more viable. 


    Some investors would never choose a replication product in the belief that alpha, defined as the return component not explained by the associated replication strategy, is being left on the table. Perhaps this argument is naive. It suggests many managers produce alpha, and that alpha managers are easy to identify ex ante. In my opinion, very few managers generate net of fee, positive alpha. More importantly, it is extremely difficult to identify these managers ex ante. This does not mean you should avoid a traditional manager. I'm suggesting that most investors are overconfident when it comes to their manager selection skills. Among other things, most people place too much weight on ex post, past returns – returns that had an approximately 50% chance of being positive by luck alone.

    Of course, not all bottom-up replication products are created equal. Similar to traditional hedge fund manager due diligence, make sure to thoroughly underwrite the bottom-up product. Come up with realistic, conviction-adjusted risk and return assumptions for all competing alternatives and choose the one that best meets the overall portfolio objectives subject to the institution's resource constraints. However, if a traditional hedge fund manager is chosen over a replicator product, for assessing manager skill, make sure one of the manager's benchmarks is the replication alternative on a risk-adjusted basis. Because the replication product is a viable alternative, i.e., opportunity cost, this is a better way of assessing the manager's true alpha capabilities.

    The benefits of understanding bottom-up replication

    Within the subset of strategies that are more replication prone, it is critical to measure and assess the differentiated component of a manager's process and return. This cannot be done without fully understanding the process and return of the replicator alternative. The alternative will inform the types of questions to ask, the types of data to request and the types of performance attribution/risk analytics to run. Asking the manager if he/she is mainly implementing a “well-known” trading strategy is unlikely to lead to a transparent, fair and balanced answer. This is not because the manager is necessarily dishonest, but because we all like to think we are providing something special and not simply a commodity service. Investing the time to fully understand bottom-up replication will dramatically improve your manager due diligence and monitoring processes.

    Even within the subset of strategies that are less replication prone, the knowledge from bottom-up replication is helpful. First, some “discretionary” managers implement systematic trading strategies/screens that overlap well with the replication crowd. To successfully identify them, you need to fully understand bottom-up replication. Second, many discretionary managers have a systematic component to their investment process that might have some overlap with the replicators. If it does, it is important to understand the magnitude of the overlap to assess “value add/differentiator” type questions. If it does not, it's important to assess the likelihood that it will eventually become “public knowledge” and be incorporated in various replication products.

    Financial innovation

    One of the stated benefits of bottom-up replication products is better liquidity terms for investors. This is preferred, however, only when the liquidity terms of the investment vehicle are consistent with the liquidity of the underlying assets and strategy. When underwriting a bottom-up replication product, remember to examine potential liquidity mismatch during normal and stressed market environments. For example, assess how the product would perform when many investors seek liquidity at the same time — a common occurrence in stressed markets. To better meet this “asset-liability” liquidity condition, some replication strategies have altered the amounts and types of securities utilized in the set of systematic trading rules. This is a good thing, but it does not come free. Many strategies garner a non-trivial amount of expected return by taking on some form of illiquidity risk. This is true even for many public-equity-based strategies.

    While hedge fund replication is a positive innovation for investors, mainly focusing on fees, liquidity and transparency provides an incomplete picture. A strategy that is now easily accessible and facing increased competition will have different forward-looking risk and return properties than the original, private, inaccessible strategy. Prospective long-run expected returns on replicator strategies therefore, will probably be lower than in the past. Additionally, the combination of more capital and more liquid investment vehicles could alter the prospective volatility, correlation and tail risk properties of replicator strategies.

    Peter Hecht is vice president, senior investment strategist, investments at Evanston Capital Management.

    Related Articles
    The efficient market hypothesis is our North Star
    Deutsche Bank: Lack of transparency biggest reason for rejecting hedge fund inv…
    Under the hood of hedge fund leverage
    Evanston Capital Management names business development head
    The role of hedge funds in institutional portfolios
    Finally, a practical solution for decomposing returns into alpha and beta
    What every allocator needs to know about hedge fund replication
    Recommended for You
    ONLINE_170729815_AR_-1_WQFKOCKSIIXQ.jpg
    Clearlake Capital docks seventh flagship fund at $14.1 billion
    Gila Cohen
    Monroe Capital brings on managing director for institutional partnerships
    Apollo_Logo_i.jpg
    Apollo takes stake in life sciences VC firm Sofinnova Partners
    Alternatives: Investing Across the Spectrum
    Sponsored Content: Alternatives: Investing Across the Spectrum

    Reader Poll

    May 9, 2022
    SEE MORE POLLS >
    Sponsored
    White Papers
    Are Factors a Thing of the Past?
    Q2 2022 Credit Outlook: Carry On
    Leverage does not equal risk
    Is there a mid-cap gap in your DC plan?
    Out of the Shadows: The Revolution in Shadow Accounting
    The pivotal role of fixed income markets in the ESG revolution
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    May 9, 2022 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2022. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Consultants
      • Coronavirus
      • Courts
      • Defined Contribution
      • ESG
      • ETFs
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Opinion
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Russia-Ukraine War
      • SECURE Act 2.0
      • Special Reports
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • Climate Change: The Inescapable Opportunity
      • Impact Investing
      • 2022 ESG Investing Conference
      • ESG Rated ETFs
    • Defined Contribution
      • Latest DC News
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • Trends in DC: Focus on Retirement Income
      • 2022 Defined Contribution East Conference
      • 2022 DC Investment Lineup Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Performance Data
      • P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
      • Future of Investments Research Series
      • Charts & Infographics
      • Polls
    • Careers
    • Events
      • View All Conferences
      • View All Webinars
      • 2022 Innovation Investing Conference
      • 2022 Defined Contribution East Conference
      • 2022 ESG Investing Conference
      • 2022 DC Investment Lineup Conference
      • 2022 Alternatives Investing Conference