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What Should Investors Expect From Hedge Fund Replicators?

Contemplate before you replicate.

Terry Tian, 05/10/2012

Hedge fund replication is one of the investment industry's latest innovations. The three largest mutual funds employing this strategy have gathered nearly $4 billion in assets over the past four years. Although grounded in academic theory, these products can be quite complicated in practice. As with any investment, investors must understand the strategy's intricacies and set expectations accordingly before buying in.

Why Replicate?
Over the past 60 years, hedge funds have delivered returns that have a low correlation to stocks and bonds, attractive downside protections and superior alpha-generating capabilities (for some hedge funds, at least). They are infamously expensive, too. The typical "2 and 20" fee structure is worth paying only if the manager has superior skill. Unfortunately, a great portion of hedge fund managers do not, and investors are paying alpha fees for beta performance at best.

The hedge fund beta exposures are much more complicated to analyze than traditional mutual funds', but over time, they are an important driver of hedge fund returns. If a replication strategy can successfully identify these beta factors and find liquid financial instruments (such as exchange-traded funds and futures contracts) to proxy them, it can get the hedge fund risk exposures (and therefore the distribution of returns) with much lower costs.

Besides providing "hedge-fund-like" beta exposures, replication strategies have mainly two additional benefits relative to direct hedge fund investing. First, replication strategies come with high liquidity. When investing in hedge funds, investors are usually subject to a standard lockup period and restrictive redemption policies. Replication strategies, on the other hand, invest in liquid ETFs and futures contracts and, like all other mutual funds, offer daily liquidity.

Second, while poor transparency increases the operational risk and cost of due diligence involved with hedge fund investing, replicators disclose their portfolio holdings and are subject to regulations by the SEC. Lower fees, greater liquidity, and better transparency make hedge fund replication a much more investor-friendly option for those seeking hedge-fund-like exposures.

Limitations of This Approach
Before jumping in headfirst though, investors must also consider the inherent limitations of most hedge fund replication strategies. First and foremost, a replicator's returns depend on the pool of hedge funds that they choose to replicate. But because of the voluntary nature of hedge fund reporting, most databases (and therefore indexes) are plagued by survivorship bias, backfill bias, and self-reporting bias. In this unregulated industry, both top and bottom performers have little incentive to report to a database. As a result, replicators are left with an incomplete picture of the industry.

Second, replication strategies are constrained by the availability of liquid instruments. Not all factors driving hedge fund returns match up nicely to liquid proxies (certain arbitrage or commodity carry factors, for example, are very hard to mimic). As a result, these financial engineers are forced to settle with less-prominent factors. Matters are further complicated by the reality that portfolio managers can easily fall victim of "correlation mining" bias--the data can be manipulated so that it appears correlated to any number of possible factors.

Third, by design, replication strategies are mostly backward-looking. Hedge funds typically report their performance to databases with at least a one-month lag. As a result, replicators can only base their analysis on the hedge funds' return streams up to the previous month. This usually means that their models hold great explanatory power but limited predictive power.

Terry Tian is an alternative investments analyst at Morningstar.
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