Hedge fund clones grow in appeal

Date: Monday, July 6, 2009
Author: Steve Johnson, FT.com

Pioneers of hedge fund replication are reporting rising interest as investors consider returning to the asset class but remain wary of the underlying industry’s poor record on liquidity and transparency and its sky-high fees.

State Street Global Advisors said its Premia clone had doubled in size to $400m (£244m, €285m) in the past year and that it was in final stage discussions with several more institutions.

“Investors are reassessing their exposure to hedge funds. Once they re-emphasise their commitment there will be a huge amount of searches and I think hedge fund replication will account for a large part of the pool,” said Michael Arone, head of EMEA product engineering at SSGA.

Andrew Lo, a Massachusetts Institute of Technology professor and manager of two replication funds operated by AlphaSimplex, added: “We are also seeing a pick-up in interest. [The replication industry] has done what it said it would do in terms of tracking the broad-based performance of hedge funds.”

Replication strategies are designed to produce the investment returns of the broad hedge fund industry, without having to invest in the funds themselves.

Most strategies involve taking long and short positions in a dynamic basket of liquid assets, such as equity futures, Treasury bonds and currencies, to attempt to recreate the positioning of the underlying industry. Fees are significantly lower at 50-100 basis points a year.

Meaningful performance data is starting to emerge for a number of products launched in 2006 and 2007 and the concept appears robust – in spite of a failure to follow hedge funds all the way down during the annus horribilis of 2008.

Mike Powell, head of alternative assets at the UK’s Universities Superannuation Scheme, which has invested £200m in hedge fund clones, said: “In aggregate they have outperformed the hedge fund indices since inception.

“Generally they did very well last year because they did not suffer from the illiquidity issues.

“This year they are slightly lagging the individual managers, it takes a while to catch up with changing allocations.

“We still feel that replication has a role to play in providing us with cheap, liquid exposure.”

Yoni Epelbaum, managing director of equity derivatives at Bank of America Merrill Lynch, said of Merrill’s Factor Index: “It has had a 90 per cent correlation with the HFR global returns index.”

Replication strategies had previously struggled to raise assets, with investors wary of anything to do with hedge funds or innovative “black box” structures during last year’s turmoil.

A source at one bank admitted: “We are nowhere near where we thought we would be.

“Going through the fiduciary committees, the consultants, getting through the guards, that’s a tough slog.” But there are indications that clones now tick many of the boxes institutional investors are focusing on.

“Clients need transparency and liquidity, they do not like lock-ups or want high fees. We have daily liquidity, full transparency and avoid single manager risk,” said Mr Arone.

Tim Jennings, an executive director at JPMorgan, which has almost $1bn in its Alternative Beta Index, said: “We are seeing interest across institutional investors. They are saying ‘maybe I can’t find the next Renaissance, maybe I’ll just get the hedge fund beta, then I don’t have the Madoff issues.’. It’s a much safer way to play.”