Hedge funds and clones

A new research paper sheds light on recent developments on financial products that are linked to hedge funds. In How do hedge fund clones manage the real world? (available at www.caia.org) researchers Nils Tuchschmid, Erik Wallerstein and Sassan Zaker examine the performance of so-called hedge fund clones—financial products that are designed to mimic the performance and volatility of major funds.

After the global financial meltdown of the last year, hedge funds have been under considerable stress globally. The operations of all such funds have been viewed as being non-transparent, not subject to regulatory oversight, and high-risk, high-return operations that are run away from the limelight of financial markets. The very nature of their operations has made them costly, in the sense that payments of upfront 2% fees and 20% of profits are the norm rather than exception. There have also been several scandals connected with hedge funds in the last year, most notably the Bernie Madoff one, which has reduced investor confidence in these funds and their operations.

At the same time, investors have been keen to return to this asset class, while remaining wary of the underlying industry’s poor record on liquidity and transparency as well as its sky-high fee structures. To meet this demand, several firms have come up with new types of investment products that try to clone or replicate the strategies of hedge funds in the hope of reaping some outsized returns with minimized fees and lock-in periods for end clients. These strategies have not been around long, but interest in them is growing rapidly, primarily due to low fees that these products charge—just 1% compared with the “2 plus 20” of normal hedge funds. More importantly, these products are liquid, exits are easy and the products—along with the fund—are also registered with regulators for regulation as indices. They suit the retail investor, for they bring about transparency, low fees and regulatory control, while attempting to perform as well as the hedge funds themselves.

Most of these hedge fund clones are structured as premium indices and use the “factor model approach”. This approach creates the hedge fund clones by looking at the performance over the last set period of time such as one year and then figuring out what securities you would have had to hold to achieve those returns. This is why many researchers on the academic and professional side of the investment industry have doubts about the returns that hedge fund clones will produce. Hedge fund clone indices may be superior to several other indices in terms of total return, but it is unreasonable to expect an index to keep up with the returns of the top 20% of hedge funds—which is what partially motivates high net-worth individuals to invest in hedge funds in the first place. This is an important point to understand as this approach has been criticized as simply creating a similar risk/reward portfolio to hedge funds without any of the underlying diversified assets of the adjusted portfolios of true hedge funds.

After an examination of 21 such hedge fund clones, the research paper concludes that these products are broadly succeeding in investment returns of real hedge funds, and several have done fairly well even over the recent market downturn. Interest in these products is, therefore, growing, though there is no promise that these products will not come to grief in the same manner as the base funds that they attempt to clone.

There are other products entering the financial sector as well. As new products emerge, certain underlying assumptions appear to be unchanged. First, there is a large and growing class of investors that is not risk averse, is not satisfied with the return on mutual fund-based strategies and is also uncertain about the volatilities of equity markets. As economies grow, so will investible funds with these investors. In short, the greed for greater- than-market returns, which was fuelled by the last boom, is still very much there and has not been dampened by recent events. Second is that products in the market are likely to get more esoteric and mathematical, and though regulatory oversight may well be promised, offshore regulators may be ineffective in the event of serious market stress. There is little that product innovators have learnt from the recent crisis, and collateralized debt obligations (CDO) and credit default swaps (CDS) may well be replaced by other cleverer instruments. There is little evidence that oversight, regulation and monitoring of these products is going to be better in the future than in the past— and hence the risks to the financial sector are likely to become systemic risks, not just a single 2007-08 event. Even more worrying is the fact that these system risks may work their way into the real economy of the goods and services sectors—and there is, as yet, inadequate understanding about how exactly these transmissions take place, about timelines, lags and magnitude. It is likely that these effects may differ for different countries, given the differing structure of the economies.

It appears as though little has been learnt from the meltdown, at least in financial markets.

S. Narayan, a senior research fellow at the Institute of South Asian Studies, Singapore, is a former finance secretary. We welcome your comments at policytrack@livemint.com