Hedge fund replication potential highlighted

Date: Thursday, March 27, 2008
Author: Andrew Sheen, Global Pensions

UK – Hedge fund replication has moved into the spotlight following the Universities Superannuation Scheme’s £200m allocation to the strategy.

This represents one of the largest allocations to hedge fund replication in the UK and could mark a shift toward increasing use of alternative beta products in the UK pension universe.
Mike Powell, head of alternatives at the £30bn USS, told Global Pensions: “Our view, supported by academic research, is that the majority of hedge fund returns are derived from beta, which can be replicated.

“Persistent alpha [...] is scarce and therefore difficult to access for large funds with significant capital to deploy. We do not want to pay alpha type fees for beta derived returns.”

Kanesh Lakhani, managing director, State Street Global Advisors (SSgA) UK, which secured the USS mandate, said: “About 80-90% of long term hedge fund returns can often be explained by factors other than management and therefore replicated.”

The Hedge Fund Research Index (HFRI), a composite index of hedge fund of fund performance has shown a year-to-date return of -1.2% net of fees. Despite the extremely short-term nature of the data, the comparison between this and a range of replication products shows a marked discrepancy in performance.

Deutsche Bank’s Absolute Return Beta Index and Goldman Sachs Absolute Return Tracker posted a 6.8% and 1.4% YTD underperformance respectively, with an average underperformance across seven hedge fund replication products of 4.2%.

Phil Irvine, director of advisory services with hedge fund consultancy Liability Solutions, said it was too soon to tell whether hedge fund replication strategies were an attractive alternative and cautioned that investors need to look at long term performance.

“A year ago I said I thought it was likely that down markets would be the true test of replication techniques,” Irvine said. “The term ‘replication’ is a bit of a misnomer as it is not the same as an index.”

Powell disagreed with this added: “Of the five replication funds we monitor, the majority outperformed the HFRI Fund of Funds index during 2007 and significantly outperformed the investable hedge fund indices over the same period.”