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Top hedge fund clones add to fee pressure


Date: Monday, September 28, 2009
Author: Steve Johnson, Financial Times

The performance of synthetic hedge fund clones is strong enough to start to put pressure on the high fees charged by many real hedge funds, according to a comprehensive academic review of the controversial concept.

A swathe of hedge fund replication products have been launched by banks such as Goldman Sachs, JPMorgan, Barclays Capital and Bank of America Merrill Lynch since 2006.

They are designed to replicate the underlying exposures, and therefore performance, of the hedge fund industry at a fraction of the typical “2 and 20” hedge fund fee structure (2 per cent of assets and 20 per cent of returns). Clones typically charge a flat fee of 1-2 per cent of assets.

The clones are also highly liquid, allowing investors to escape the gating and suspension of redemptions that plagued the industry in the wake of the financial crisis. They also bypass the risk of losing money to a fraudster such as Bernard Madoff.

Now analysis* by Erik Wallerstein and Nils Tuchschmid of the Geneva School of Business Administration and Sassan Zaker of Julius Baer Asset Management suggests the clones are broadly succeeding in replicating the investment returns of real hedge funds.

The report, which looked at 21 clones over the period April 2008 to May 2009, concluded: “Hedge fund replication products seem to deliver competitive performance relative to hedge funds. More importantly they are able to deliver this at a far lower fee level than hedge funds.”

“If they get enough attention and assets under management then I believe they will exert some fee pressure on hedge funds. Then it will be difficult for hedge funds that do very similar things,” said Mr Wallerstein, who believed that strategies such as long/short equity and some fixed income-based approaches were easiest for the clones to replicate.

The research found that the vast majority of clones exhibited a correlation of at least 70 per cent to industry benchmarks operated by Hedge Fund Research and Credit Suisse/Tremont.

Most lost less than the typical 10-15 per cent declines recorded by the industry at large, although Mr Wallerstein cautioned that the relative performance of clones in a bull market remained unproven. “Shortable” clones, which allow investors to benefit from losses in the underlying industry, appear to succeed in mirroring long approaches.

However, the researchers warned some clones exhibited too much correlation with equity markets and also raised fears that replication models were becoming “increasingly complex”, presenting a barrier to investors wary of opaque “black box” strategies.

The report also suggested that clones have yet to gain widespread backing from investors, with total assets potentially as low as $2bn. It found some replicators received redemption requests for as much as 80 per cent of their assets in the autumn of 2008, largely because they offered better liquidity than underlying hedge funds.

Separately Edhec, the French business school, released a report** claiming that none of the clones has thus far generated “fully satisfactory results”, with their performance “systematically inferior” to actual hedge funds. Edhec judged equity market neutral and risk arbitrage strategies as amongst the hardest to replicate.

It judged the concept as “very much a work in progress”, although clones “might still be useful” to investors and fund of hedge fund managers, Edhec said.