A small but growing number of institutional investors are abandoning hedge funds in favor of their clones — hedge fund beta portfolios.
But those still making up their minds had better hurry: The industry's largest hedge fund beta manager, AQR Capital Management LLC, is running out of capacity and few other institutional-quality strategies are ready for prime time, consultants said.
Interest among institutional investors in rules-based hedge fund beta strategies is growing, part of “an evolution of the understanding of hedge fund returns,” said Steven J. Foresti, managing director and head of the investment research group of the consulting unit at Wilshire Associates Inc., Santa Monica, Calif.
“The more you understand systemic beta or the risk premium, the better able you are to separate from it pure alpha or the information edge. In 10 years, we won't be talking about alpha the way we do now. Alpha is a black box and it's being smashed open, which is a very positive process for hedge fund investors,” Mr. Foresti said.
Consultants said institutional investors are using hedge fund beta strategies as a replacement for some or all of their hedge funds-of-funds managers; as a tactical investment; and as transition vehicles during hedge fund manager changes.
Among the investors that have invested in hedge fund beta strategies are the $3.8 billion Fire & Police Pension Association of Colorado; the C$188.9 billion (US$182.6 billion) Canada Pension Plan Investment Board; the $6.6 billion Sacramento County (Calif.) Employees' Retirement System; and Oregon Investment Council, which runs the $63 billion Oregon Public Employees Retirement Fund.
The first generation of factor- and regression-based hedge fund replication strategies was largely unsuccessful in synthetically producing returns close to those of hedge fund indexes, sources said.
Current replication strategies don't try to reproduce index returns. Instead, these approaches are using bottom-up, systematic, rules-based processes to identify hedge fund beta sources that better mimic returns of specific strategies. The approaches are very liquid, far more than actual hedge funds, and offer a much cheaper way to get exposure to hedge fund strategies that derive most of their return from market activity, observers said.
The estimated cost range for hedge fund beta portfolios is 75 basis points to 250 basis points.
Still, investors will continue to seek out the very best alpha-producing hedge fund managers. Institutional investors stressed they are willing to pay the weighty price — a 1.5% to 2% management fee and a 15% to 20% performance fee — for true outperformance over market returns.
The $264.6 billion California Public Employees' Retirement System, Sacramento, is among the funds exploring hedge fund beta strategies.
One firm close to launching internally managed hedge fund beta portfolios is Dutch fiduciary manager PGGM Vermogensbeheer BV. PGGM manages €140 billion ($187 billion) on behalf of clients of its parent, Pensioenfonds Zorg en Welzijn. Both entities are in Zeist, Netherlands.