Send in the clones
Oct 29th, 2006 | Filed under: Alternative Beta & Hedge Fund ReplicationBy: The Economist
Published: October 28, 2006
Maybe Alpha Male wasn’t the only one paying particularly close attention to David Hsieh’s recent opining about “hedge fund beta”. This week’s Economist cited his research in a story about the rising interest in “cloning” hedge funds using cheap, liquid instruments.
“The result could be a cheap competitor for the hedge-fund titans, akin to the index-tracking funds that have eaten into the market shares of active fund managers.”
Several studies have recently concluded that a portion of hedge fund returns, taken together, can be explained by a series other “risk factors” (e.g. equity markets, spreads etc.). But we believe this dialogue is missing a key point: hedge funds are not an asset class.
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AM
I obviously agree with Hsieh’s comments on the amount of alpha per player. But now that this is in the Economist, a place where hedge funds are discussed in roughly just about every other issue, it really makes me wonder. I’ve been following the concept of “beta management” in the hedge fund space for a while and am beginning to wonder about how the industry is really viewing this development. Where’s the value of this focus on beta and a move away from manager selection? Lower costs to attract more institutional investors? Less need for active managers and thus the ability to provide greater transparency (process/positions/whatever) to these same institutional investors?
For example, Asian hedge funds and FOFs with an Asian bent are quite popular now. Perhaps due to the higher perceived potential for alpha in this area, especially with regard to China … I personally wonder just how much shorting can be relied upon in this space. Anyway, suppose I’m an Asian focused HF/FOF based in Hong Kong. I’m trying to get into the typical names (Yale, San Diego, Ontario Teachers, etc.) and I’m going up against others in this space (Asian HF). Clearly, I need to differentiate myself based on the above criteria (cost, transparency requirements, etc.) among others.
So I’ve got to wonder if putting a certain amount of my overall program, (X% whatever that is?!), into something that is a hedge fund return replication strategy would be a key “selling point”. What would San Diego think about this line of thinking considering how much press they’ve received regarding Amaranth?
I would guess that having someone like Hsieh, Kat, Jaeger (I know, he’s a practitioner not an academic) or similar individual would be nice to have as an advisor to back the mandate’s proposal when pitching to the fund sponsor. However, wouldn’t one just be transfering the manager risk? Although you’d be moving from something that smells like true alpha to something that smells more like beta, you’re still relying on someone’s recipe to deliver the goods. Somehow, I don’t see this as a reduction of manager risk … and certainly not the elimination of it.
There has been quite a bit of discussion lately about the demise of the FOF space. Some say multistrategy will continue to capture “market share” (not the proper term in this case) from FOFs as investors question the value of the added cost layer. With continued research, I believe we’ll soon know much more about just which of the underlying hedge fund strategies actually have the best shot of being replicated using a “beta oriented” strategy. If this happens, I fear less for the specific strategy and single strategy HF managers in that space than I would for the FOFs.
The parallel to this is for the typical long only vanilla investor. Divide your world by asset classes. Within each asset class, determine how much you believe that space to be “efficient versus inefficient” and implement accordingly … in other words, determine how much to invest using ETFs/derivatives versus active strategies/managers.
Imagine yourself running a FOFs right now, and seriously consider all the underlying strategies currently invested in or are looking to invest in. Knowing what you know from just this website, would it be reasonble to quickly try to determine if a replication mandate is in the cards for any of the underlying hedge fund strategies. I think the answer right now is a definite no, but they’ve got to be paying attention to new developments.
It may just be that in time, and with research conducted over a significant period of time, hedge fund strategies will become “betaed” and new strategies will be put into the FOF portfolio that may or may not likewise become “betaed” in time.
I suppose one of the skills needed will be to determine when to make the switch to beta (use of replication strategy). Knowing what I know of higher moment analysis and other statistical factors, I don’t think it will be the same as determining when to switch out of my Indian or Eastern European manager for an ETF.
Lastly, AM, you say from your recent polling on upcoming topics that “ETFs” looks like a dark horse. Based on your recent focus on beta and replication strategies, this one looks strong comin’ round the bend.
[…] Going Private refers to The Economist’s “Send in the Clones” and the New York Times coverage of Lisa Rapuano and concludes (quite rightly, we believe) that: “…it seems reasonable to suggest that separating the fee structures of alpha and beta returns might also be a useful endeavor”. […]
[…] It’s official! We’ve run out of colourful headlines about hedge fund “clones”. What was once a headline editor’s dream has quickly become a clone itself. (see “Attack of the Clones May Hurt Hedge Funds” - Nov. 21,  ”An attack of the clones could spell end of 2 and 20” - Nov. 15). Hedge Fund cloning researcher Harry Kat has even dubbed an upcoming conference presentation “Attack of the Clones“.  ”Attack of the Clones” narrowly edges out The Economist’s “Send in the Clones” as the most cheesy headline on this topic.    […]