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DJI plans hedge fund 'clone' launch

Date: Monday, November 13, 2006
Author: Steve Johnson, FT.com

Dow Jones Indexes is in talks to launch the world's first investable index trackers designed to mimic the behaviour of a range of hedge fund strategies.

The artificial trackers would potentially allow investors to access the returns of hedge funds without having to pay the high fees demanded by the industry, typically a 2 per cent annual fee and a 20 per cent performance fee.

If successful, the initiative would pose a threat to hedge funds that merely generate the beta of their chosen trading strategy without generating sufficient alpha to justify their high fee structure.

"We are thinking about this and are talking to institutions. I'm confident that it will happen," said John Prestbo, executive director of Dow Jones Indexes.

"We have gone through a period where everyone can proclaim to be a hedge fund manager. That kind of nonsense will be weeded out by these indices."

His comments come just days after Blake Grossman, chief executive of Barclays Global Investors, the world's biggest money manager, warned there were "too many" hedge funds and that pressure on them would grow to justify their fees.

DJI already operates a suite of hedge fund indices that invest in a basket of managed accounts operated by hedge funds. Now it believes it can go a step further and create the same performance attributes by investing directly in the assets that these hedge funds ultimately invest in.

"Theoretically, we can build a model that mimics the behaviour of the hedge funds," said Mr Prestbo, who believes the approach is best suited to strategies where performance is largely determined by market factors and there is adequate liquidity, such as equity long/short, equity neutral, convertible arbitrage and fixed income arbitrage.

Wider roaming strategies, which are seen as relying more on fund manager skill such as global macro, would be harder to replicate.

The mechanical index trackers would also be a huge boon to transparency in the notoriously opaque hedge fund sector as DJI would publish the rules determining the construction of each clone, replacing the "black boxes" of the industry with a "glass box".

Fees would be lower than those charged by existing hedge funds although a need for high levels of turnoverin each portfolio maymean charges remain higher than for long-only index trackers.

Benjamin Bowler, analyst at Merrill Lynch, predicted cloned hedge fund strategies would become commonplace.

"There are potentially ways you can use rules-based strategies to reduce the cost of generating hedge fund-type returns. These strategies will become increasingly attractive," said Mr Bowler, who doubted there were enough talented hedge fund managers to cope with an expected doubling of the sector to $2,500bn. "This is similar to the upspring of passive money in traditional fund management that we saw 20 years ago," he added.

However, Harry Kat, professor of risk management at London's Cass Business School, was cautious about the accuracy of such replication techniques.

"You can explain up to 60-70 per cent of the return for funds of funds specialising in equity long/short; you can call that replication," he said. "For equity market neutral, the fit will be a lot less. The same for fixed income arbitrage - there are a lot of different games they can play and it's hard to replicate that."

Mr Prestbo speculated that the clones could be launched if and when equity markets weakened.

"When markets are going up that doesn't breed change. When markets turn, different arrangements must be made.

"This might briefly accelerate turnover, that is to say hedge funds closing down because they can't deliver anything but beta. There are lots of weeds in the garden."