Duplicating Hedge Funds: Six Justifications
In the world of finance, hedge fund replication strategies are gaining traction as a cost-effective and transparent way for investors to access diversified hedge fund-like exposure. These strategies offer several advantages over traditional hedge funds and liquid alternatives.
Diversification is one such advantage. Replication strategies provide broad exposure across asset classes or sectors by tracking indices or portfolios, reducing the idiosyncratic risks associated with individual investments. This wide exposure helps achieve better diversification than some single-manager hedge funds or liquid alternatives.
Fees are another area where replication strategies shine. They are generally far more cost-efficient than traditional hedge funds, which often charge high management and performance fees. Lower costs come from passively tracking an index rather than active management.
Liquidity is another key benefit. Replication strategies are commonly executed through highly liquid vehicles like ETFs that trade daily on exchanges, allowing investors to buy or sell shares with ease. This contrasts with traditional hedge funds and many liquid alternatives, which may have longer lock-up periods or limited redemption windows, reducing liquidity.
Risk is also lower with replication strategies. They aim to consistently track a benchmark, thereby producing more predictable and stable returns relative to the more variable returns of traditional hedge funds that rely on active manager skill. Although replication may not generate alpha like active hedge funds, it typically offers lower complexity and risk transparency.
However, it's important to note that replication may not be effective for highly illiquid strategies. Top-down replication has not proven effective with hedge fund strategies that deliberately minimize any clear market exposures.
The success of replication is grounded in research on what drives hedge fund performance. Allocators who build diversified model portfolios can match or outperform the hedge fund indices used in capital market assumptions, but without single manager risk or high fees. Fee disintermediation may be a way to generate alpha in replication strategies.
Replication strategies seek to match or outperform hedge funds by investing directly in the market factors that drive performance. Equity long/short and many other hedge fund strategies' replication portfolios can outperform materially by capturing 80% or more of "pre-fee" performance. Managed futures replication portfolios can deliver all pre-fee returns, providing a 300 bps "head start" relative to investing in high cost hedge funds.
Retail investors can also benefit from replication strategies. They can improve diversification while investing only in regulated funds, like mutual funds and UCITS vehicles. The Clear Alpha Global Index is designed as a benchmark for the universe of trading strategy indices.
In summary, replication strategies give investors cost-effective, transparent, and liquid access to diversified hedge fund-like exposure with lower fees and more predictable risks than traditional hedge funds and many liquid alternatives. However, this may come at the expense of the highest possible alpha generation that skilled hedge funds seek.
[1] Source: Research Affiliates [2] Source: BlackRock [3] Source: AQR Capital Management [4] Source: Vanguard Group
Investing in technology can play a significant role in implementing replication strategies, as it enables the efficient tracking of diversified indices or portfolios. Moreover, technology facilitates the execution of transactions in highly liquid vehicles like ETFs, thereby providing accessible and easy liquidity for investors.
