Hedge Fund Clones: The Benefit of Liquidity and the Promise of Average Hedge Fund Returns

by Arek Leoniuk
J.P. Morgan Investment Analytics & Consulting
arek.x.leoniuk@jpmorgan.com

Institutional investors may want to achieve average hedge fund returns with high liquidity when considering allocation to alternative investments. In this vane, there are a growing number of studies and product releases in the field of hedge fund beta replication. In theory, hedge fund beta replication seeks to provide alternative exposure with lower fees, less risk, and higher liquidity. Beta replication attempts to break down hedge fund returns into different risk-attributable return components.

Products Attempt to Achieve Liquid Hedge Fund Exposure

Using liquid exchange-traded products, hedge fund beta replicators attempt to mimic the systematic returns generated by a model hedge fund universe while avoiding illiquidity risk, market timing risk, and poor stock selection. Beta replication rests on the premise that most risk factors can be attained, measured, and replicated through regression analysis and other quantitative means. The replication model in its simplest forms uses linear regression analysis on the funds’ risk exposure levels to the funds’ risk factors. The hedge fund replication model invests in liquid, exchange-traded products to achieve the most recent risk exposures.

Studies show that 90% of a portfolio return is generated by asset allocation. According to Jaakko P. Karki, PhD, CAIA, and Tapio Pekkala, PhD (“Beta Replication: A Cost-Effective Alternative to Hedge Fund Investing”), beta return accounts for approximately 80% of hedge fund returns. Terrapin and AllAboutAlpha.com conducted a survey of 180 institutions, including asset managers, end investors and consultants. The study found that 7% invested in hedge fund beta replication or other forms of alternative beta in 2007, and that the figure is expected to grow. According to the survey, beta replication’s top attribute is liquidity through exchange-traded funds. Lower fees was the second most important benefit, with others being transparency, performance, and lower operational risk. The main drawback or cause for hesitation for most was the fact that the product offers only average hedge fund returns through systematic risks. Other concerns included limited knowledge about the vehicle, as well as the lack of long track records and the perception that hedge fund returns cannot be replicated through a quantitative strategy.

Hedge funds overall outperformed general equity asset classes in 2008, yet have struggled to gain positive ground in the downward trending market (Exhibit 1).

Exhibit 1: Equities and Hedge Funds Return (as of Dec. 2008)
Source: J.P. Morgan Investment Analytics and Consulting estimates, Bloomberg

Returns among different strategies vary, but most hedge fund indices are showing double-digit losses. In Exhibit 2, we summarize the recent performance of various hedge fund indices.

The poor recent performance of hedge funds does not bode well for replication products as generally hedge funds seek absolute returns.

Nevertheless, institutional interest for hedge fund beta replication products seems to be growing. Higher demand has created opportunities, exampled by several recent funds launched in the fourth quarter. One such strategy attempts to achieve the betas of a broad universe of hedge funds rather then a selected index by estimating and attempting to reproduce beta factors attributable to the expected return of going long and/or short using futures and forward contracts.

Where’s the Beta?

Systematic beta products can be a useful tool if they manage to capture 80% of absolute returns. However, talented hedge fund managers may argue that some aspects of systematic beta are debatable and could actually be considered alpha.

Let us consider an example. If one of the hedge funds within our universe had decided to pull out of all assets and invested solely in cash for Q4 of 2008, the manager would have generated a return of approximately 0.274%, the performance of the U.S. Treasury Bellweather 3-Month Index. During the same period, the Credit Suisse/Tremont Hedge Fund Index returned -10.214%. Although cash instruments are considered beta-replicated factors, it was the manager’s intent to deviate from other asset class risks. To some, this would be a clear example of alpha – the value added by a true and well-selected timing of the market. On the other hand, quantitative supporters may view this as an adjustable quantitative risk factor. The quantitative-adjusted risk factor results will always follow the adjustments managers choose to make, in which case it would seem that the beta quantitative strategy is following the footsteps of an alpha-generated idea (as allocation is shifted when market environments change, which is a timing aspect of decision making).

One risk that should also be considered when evaluating the strategy is adjustment risk. Understanding that a quantitative strategy follows alpha-generated ideas, there must be a lag for the adjustments from the actual allocation shift of the manager. If the products adjust on a monthly basis – much like the Merrill Lynch Factor Index, which uses six index factors calculated over 24 months – and given our understanding of the importance of allocation, how well will these strategies do in periods of extreme volatility?

Using a multi-factor analysis on a range of different hedge fund strategies, Karavas, Kazemi and Schneeweis found the Exhibit 3 results in a 2003 study.

As clone strategies pool up model hedge funds to mimic risk, most commercial efforts in replicating hedge fund returns are based on models with constant parameters, according to Noel Amenc, Walter Gehin, Lionel Martellini and Jean-Christophe Meyfredi. The constant parameters aimed to replicate a dynamic hedge fund strategy can lead to higher volatility and lower returns, as the Exhibit 3 results showed.

Conclusions

It seems that beta will always be the lagging indication of systematic returns whose original placement was created by an alpha-generated idea. But given the volatile market environment today, these products will most likely gain greater acceptance and may be a worthwhile option for institutional investors to consider. The benefit of liquidity with return exposure to alternative investments seems to be the more attractive attribute rather than a potential means to replicate long-term hedge fund performance results.