Hedge fund replication: Is it appropriate for you?

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.

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.

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.

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.