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As hedge funds flop, replication funds get chance

Date: Tuesday, January 27, 2009
Author: Joseph A. Giannone, UK Reuters.com

While the credit crisis has been tough for hedge funds, it has been a shot in the arm for index-based investments that promise to mimic the returns of actively managed funds.

Pension funds and other institutional investors, frustrated by blocked redemptions and harrowing losses at hedge funds last year, are looking closely at so-called replication funds. These products are designed to deliver the performance of a hedge fund, but with less secrecy and more access to their money.

Up until recently, the funds did not gain much traction because they have a short track record. According to analysts, Merrill Lynch and Goldman Sachs Group Inc (GS.N: Quote, Profile, Research) were the first to market such products in 2007.

Yet the poor performance of actively managed hedge funds, and their decision to block redemptions at the end of last year, has encouraged investors to take a close look.

Banking on this trend is IndexIQ Inc, a tiny Rye Brook, New York, firm that launched a suite of index-based replication funds in early 2007. In July, it launched the IQ Alpha Hedge Strategy Fund for mutual fund investors.

"There is a big appetite for hedge fund replication in the institutional marketplace," said Tony Davidow, a Morgan Stanley veteran who recently joined IndexIQ as head of distribution. "We can build a broad-based strategy that lets investors understand what they're doing and how they're getting exposure."

Hedge funds became a $2 trillion industry over the past two decades by promising solid returns, regardless of market conditions. In exchange, investors tolerated secretive fund managers, high fees and limited access to funds.

But a number of managers blocked redemptions last year as investors scrambled to withdraw cash from funds pummeled by the market meltdown.

Besides charging lower fees, replication funds let clients trade in and out -- sometimes on a daily basis. As a relatively new product, the total amount invested in replication funds is a tiny fraction of the more than $1 trillion invested in hedge funds.

Banks like Goldman that sell replication products declined to comment on their offerings.

IndexIQ's Alternative Beta portfolio was down 7.3 percent in the first nine months last year, compared with a 12 percent drop in the HRFI Global Hedge Fund Index and a 28 percent fall in the S&P 500 Index .SPX for large-cap stocks.

The global financial crisis has prompted more investors to consider putting money into replication funds, which use computer models to match the returns of popular hedge fund strategies, such as those that short stocks to offset other portfolio investments, and are designed to deliver overall gains even in down markets.

Merrill and Goldman Sachs were among the first to introduce replication products that match different hedge fund indexes by investing in a mix of exchange-traded funds and other liquid instruments.

Until last fall, most investors only expressed mild interest in the replication idea. In Europe, a few pension funds, such as Sweden's AP7, a $4 billion national pension fund, and Universities Superannuation Scheme Ltd in Britain, announced plans to shift assets to replication portfolios.

Demand for the funds took off in September and October, according to replication-fund executives, as Lehman Brothers Holdings Inc (LEHMQ.PK: Quote, Profile, Research) collapsed. Even the best-known hedge fund managers were humbled as markets plunged, and investors were in a bind: They were locked into funds that were falling hard each day.

Enter the replication funds, which served a valuable role. They let investors short the hedge fund indexes, and thereby trim their exposure to hedge fund losses.

IndexIQ's Davidow, who for most of his career touted the benefits of hedge funds, says replication products offer many of the same benefits with more liquidity and transparency.

"We offer all of the positive attributes and eliminate the negatives -- lack of transparency, excessive fees and a lack of liquidity," he said. "With many hedge funds, the reality is you're paying alpha fees and getting beta results." (Editing by Jeffrey Benkoe)