Hedge Fund Replication Not in Cards For Dow Jones

Date: Wednesday, December 6, 2006
Author: HFN Daily Report

Contrary to reports, Dow Jones Indexes is not planning to launch an investable index tracker designed to mimic the behavior of a variety of hedge fund strategies. Naomi Kim, a representative from DJ Indexes, said quotes from John Prestbo, executive director, stating the company was going to issue the first replicating tracker of its kind for hedge funds were taken out of context in a Financial Times article published in mid-November.

Prestbo was quoted in FT as saying: "We are thinking about this and are talking to institutions. I am confident that it will happen."

Kim believed Prestbo's comments were made in relation to how hedge funds were evolving and what the next step would be for the asset class, but he did not mean what DJ Indexes had in the works for the future.

The first tracker, according to Steven Umlauf, managing director of Merrill Lynch's strategic solutions group, was launched in April by ML.

"We were the first, although others got broader press," said Umlauf.

Replicating hedge funds through this kind of passive investing is starting to catch fire. In fact, Goldman Sachs was reported on Monday to have created its own vehicle. The trackers are designed to give investors exposure to hedge funds without having to pay what some consider the exorbitant fees of 2% for maintenance and 20% on earnings, as is commonplace.

The argument is that as competition in the asset class increases, it becomes increasingly difficult for managers to achieve alpha after fees. Beta is one thing, but alpha is what hedge fund investors demand.

"Hedge fund returns have come down and that is what is getting people to start to question the fee structure," said Umlauf. "If you are earning 10%, why should you pay somebody two and 20 when the S&P is earning 12%?"

Umlauf said with the explosion in hedge fund assets and managers, replicating hedge fund investments on average has become much easier. Reports on the number of worldwide hedge funds vary from 8,000 to as many as 15,000. As of the end of the third quarter, the asset class had $1.786 trillion, according to the HFN Asset Flow Report.

"They are doing more of the same stuff with liquid securities that the rest of us can buy," said Umlauf. "It is harder to produce high returns when you have got more money chasing them."

The benefits of the Merrill Lynch Factor Index (MLFI), according to Umlauf, is that investing in the vehicle has diversified hedge fund exposure with daily liquidity whereas hedge funds themselves are much more illiquid due to lock ups. The MLFI is also completely transparent. It is rules-based, meaning there is no human discretion at all. The trackers are designed to mechanically replicate the benchmark at a much lower cost.

Goldman's Absolute Return Tracker, launched this week, for instance, is said to charge investors a flat fee of 1%.

If hedge fund returns hit a snag or continue returning beta-type results, chances are replicating trackers will increase in popularity.