Buying Hedge Funds vs. Cloning Them

by: Cam Hui, CFA

Mebane Faber has a great post on the topic of hedge fund cloning. He is correct in saying that you invest in hedge funds as pure alpha vehicles (hence the high fees), not because of their correlation characteristics.

Consider the following thought experiment. If I showed you a fair roulette wheel where the house has no advantage and I told you that I was going to bet a controlled amount once a day on a spin and invest the remainder in T-Bills, such an investment would be uncorrelated to virtually any asset class that you can think of and would have highly diversifying characteristics, but would have no alpha.

Would you invest in such a fund? Would you also pay 2 and 20 for that privilege?

If hedge funds had no alpha, then that’s what you would be doing.

Do portfolio holdings tell the whole story?
Faber goes on to survey hedge fund replication techniques and finds them wanting. He goes on to extol the results of his AlphaClone service.

While AlphaClone’s real-time out-of-sample returns appear to be impressive, does that get an investor all the way there in hedge fund replication?

As I understand it, AlphaClone tracks the holdings of top investment managers through their 13F and other filings. However, there are a number of limitations to this approach, even if we assume that we can identify a smart investor universe:

  • The information may be dated, especially if the fund is a high turnover fund.
  • Limited disclosure: Many filings disclose only the long portion of the portfolio and does not show the short portfolio.
  • Less attention to weights: Some of this analysis focuses on the names of the holdings only, without paying attention to the weight. For example, Julian Robertson reportedly entered into a yield steepener trade. How big a bet is it? Does it represent 0.1% of his portfolio or 10%? Focusing on picks ignores all the other parts of portfolio management (see my previous comments here, here and here) and Dash of Insight also has a timely post on the importance of weighting differences between ETFs. I don’t know how much AlphaClone pays attention to the weightings in the portfolio but a lack of attention to weighting can prove to be a problem. One solution is to reverse-engineer a manager’s macro factor exposures like I have here.

A half-brother...
In short, I believe that approaches like AlphaClone is the next step forward in hedge fund replications, but it doesn’t get you all the way there. What you get is more like a half-brother rather than a true clone.

At this point in time, the only way to get the true exposure to these funds is to buy them, rather than to try to clone them. Whether the difference between AlphaClone-like approaches and directly buying the funds is worth the 2 and 20 fees is up to you.