Hedge fund returns without the hedge fund fees? The appeal is obvious, so it should come as no surprise that institutions are excited about synthetic hedge funds.
Investment banks have been quick to realise the potential of these new products, which use econometric models to achieve the returns of hedge funds, either through factor replication or via replication of return distributions. According to John Prestbo, editor and executive director at Dow Jones Indexes: “Investment banks Merrill Lynch, Goldman Sachs and Julius Baer have all said they are coming out with or come out recently with synthetic hedge fund products.”
How it works
There are two main approaches. One, pioneered by Harry Kat, director of the Alternative Investment Research Centre at Cass Business School, aims to replicate the return distribution of a particular hedge fund or fund of funds.
“It is based on an econometric model,” Professor Kat explains. “We take an index or fund and look at the returns in the past to show the statistical properties of the returns – volatility, correlation with stocks and bonds – and, given that information, we design a strategy that generates returns with the exact same properties.”
The idea, he says, is not to get exactly the same returns each month, but rather to produce returns over time with the same statistic properties. “That is all investors are, or should be, interested in. The order returns come in should not matter. It’s the statistical properties that matter as they determine how these assets fit into an investment portfolio.”
This approach is currently available in the form of a software licence, so investors can execute their own strategy. But Professor Kat has been in talks with investment banks with a view to launching a fund.
A rival, factor-replicating approach is being developed by Narayan Naik, professor of finance at London Business School and director of the BNP Paribas Hedge Funds Centre. “We realised that hedge fund strategies contain a lot of systematic risk factors,” says Professor Naik, “associated with bond markets, equity markets, credit markets, etc.”
Professor Naik’s team analysed three data sets for funds of hedge funds, including Hedge Fund Research data. “We found that we could explain 75-80 per cent of variations of returns over time using equities, bonds, credits, currencies, commodities etc,” says Professor Naik, “which confirms that hedge funds are not absolute return products – they are much more driven by systematic risk factors.”
Accordingly, the team invested directly in financial markets to replicate fund of hedge fund returns and found, as at the close of 2003, that 80 per cent of hedge funds of funds did not add alpha. Extending the study to the end of 2005, the proportion adding alpha slipped to only 5 per cent.
The appeal
These products could prove hugely popular. As Professor Naik puts it: “If the majority of investors in fund of hedge funds are only getting beta-based exposure, most will think, why not go directly to that.” It is also, as he notes, more liquid.
According to Chris Woods, senior managing director of absolute return strategies at State Street Global Advisers (SSgA), some institutional clients are already “amazingly enthusiastic” about the new products. SSgA has been researching synthetic hedge funds with a view to moving into the market.
The problem with hedge funds and funds of funds at the moment, he says, is fees. “Institutional investors, who will be the larger fraction of the buyers going forward, do not like paying hedge fund fees.” Synthetic products, he predicts, will get base fees down over time to around 50 basis points.
However, Professor Naik stresses, these products can be used in combination with – or even as a benchmark for – active hedge fund managers. “You can have a passive core tracking exposure and then select managers to outperform that,” he suggests.
The risks
Of course, these products are not all good news. Mr Prestbo cautions: “Each particular methodology has its own risks.” He warns that the factor replicating approach could get caught out by a change of tack in the hedge fund industry: “If the market turns and hedge fund managers adjust to that, and go off in that direction, it will be a while before the synthetic fund catches up.”
Nor is the rival approach problem free. Mr Woods warns that, as returns will not match hedge fund results on a month-by-month basis, investors may be deterred if they start off with lower than average performance.
Mr Prestbo adds that any investment methodology which uses history as a guide to the current investment mix has a tendency to become a victim of its own success, with its efficiency adversely affected as more money is poured in. “We have seen that with hedge funds themselves. A lot have attracted so much money that a lot of the opportunities existent 10 years ago aren’t as strong as they used to be.”
However, there is no doubt that this is an arena to watch, as some of investment banking’s biggest names stake a claim on the new market. “The rest of Wall Street, and firms in Europe, will be looking to see how these are received,” says Mr Prestbo. “If they attract money – and I suspect they will – then I would predict a number of other banks will come out with these products.”
