What every allocator needs to know about hedge fund replication

In the current heated debate on hedge funds, there's no middle ground. You're either pro or con, in or out, red or blue.

But this is, frankly, stupid. Hedge fund proponents make legitimate points about diversification, but fail to acknowledge where they've been flat-out wrong on many issues (e.g. wishful thinking that alpha would adequately cover fees). Likewise, the “out” camp is correct that fees are egregious, but offer no credible alternative. Redeem from hedge funds and invest in … bonds with negative yields? Equities at the tail end of the second-longest bull market in history?

The “hedge funds or bust” mantra of the “pro” camp assumes that hedge funds have some secret recipe for generating alpha, and the only way to get it is by throwing more money at high-cost illiquid hedge funds. This feels a bit … 2006. The simple truth is that what hedge funds do is not all that mysterious — they (primarily) invest in the same stocks, bonds and other asset classes as everyone else — and a lot of smart people have spent the past decade studying hedge funds to understand how they make money, what they do well, and how to offer investors the benefits (diversification) without excessive fees and illiquid, investor-unfriendly vehicles. For a lack of a better term, this movement is called “hedge fund replication,” when it really should be called something like hedge fund “distillation.”

For allocators and investors, we've put together a cheat sheet on the two primary approaches: top-down and bottom-up.

Also known as: Factor replication.

Where it works best: Equity long/short, diversified or multi-strategy portfolios, managed futures.

Where it doesn't work well: Illiquid strategies, discretionary macro.

What it says about hedge funds: Hedge funds make money from asset allocation more than security selection; hedge fund fees are way too high.

The biggest selling points: Predictable, proven performance and approach; tends to outperform due to fee savings.

The biggest drawbacks: Doesn't do well with “low beta” portfolios (except managed futures). Early products were unnecessarily complicated and undermined the “simple” thesis.

What allocators think: Funds of funds and consultants predicted it wouldn't work and were wrong. Many still threatened since it provides for a direct benchmarking of hedge fund portfolios.

The paper you should cite to sound smart: Andrew Lo's 2006 “Can Hedge Fund Returns Be Replicated: The Linear Case.”

What the paper got right: Hedge fund industry returns are easily replicated using a simple five factor model.

What the paper missed: Historical hedge fund “industry returns” were overstated, so replication likely outperformed actual hedge fund returns.

What the evidence says: Actual, live products have outperformed hedge funds since 2007; lower risk than hedge funds due to better liquidity (lower crisis drawdowns) and no position crowding.

Where you should think about using it: Replacement for high cost, illiquid hedge funds allocations; focus on ELS, managed futures and diversified portfolios.

The real question: Do investors want hedge fund returns without the mystique?

Also known as: Alternative risk premiums; Mechanical trading strategies.

Where it works best: Any simple, mechanical trading strategy like merger arbitrage or 13F replication of fundamental long/short hedge funds.

Where it doesn't work well: Illiquid strategies.

What it says about hedge funds: Hedge funds make money from alternative risk premiums, not security selection; Hedge fund fees are way too high.

The biggest selling points: Low equity beta; looks and “feels like” what hedge funds are supposed to do.

The biggest drawbacks: Wide variation in models means one “simple” strategy looks nothing like the next one. Back-tested index returns often are badly overstated.

What allocators think: Some support the concept but implementation has been problematic — see drawbacks above.

The paper you should cite to sound smart: Cliff Asness' 2004 papers, “An Alternative Future: Parts I and II”

What the paper got right: Common hedge fund trading strategies, like merger arbitrage, can be replicated using simple rules-based computer programs.

What the paper missed: “Alt risk premiums” represent a small percentage of overall hedge fund returns — not one-third as in the schematics.

What the evidence says: Hard to tell due to wide variation in products and portfolios, most of which have short live track records. Clearly, back-tested numbers were unrealistic.

Where you should think about using it: Alternative to macro or low beta hedge fund allocations.

The real question: Is this an elaborate way to get 2% returns?

Both approaches suffer from the same problem: hedge fund investors generally don't like (and typically don't want) change. It's a comfortable existence when you steer capital only to big, established hedge funds: pay 2/20 and you have every right to expect the managers to figure it out. Further, given illiquidity, once you invest there's not much you can do anyway. Go down the path of replication, on the other hand, and you have to confront thorny questions like, when is it worth it to pay 2/20, how much extra return should I demand to invest in illiquid funds, and what percentage of my portfolio should be passive vs. active? Moreover, end investors can now easily benchmark the allocators: if your hedge fund investments aren't consistently outperforming the liquid, low-cost replication strategies, what's the point? This is a scary prospect given that, for instance, top-down replication strategies have materially outperformed funds of funds since 2007. But after years of disappointing performance and startlingly little progress on fees, aren't these precisely the questions that every investor should ask today?

Andrew Beer is managing partner and co-portfolio manager, dynamic beta, at Beachhead Capital Management, New York.