Hedge Fund Replication Strategies: What's Under the Hood?

| About: Goldman Sachs (GS)

Bloomberg recently published an article that gives a sort of “state of the union” review on the hedge fund industry. The following are some interesting points that I wish to extract from this article:

  • “Since 2000, the secretive world of hedge funds has more than doubled in size. There are now more than 9,000 of these funds with combined assets of $1.34 trillion. Everyone from Wall Street chieftains to the stewards of retirement nest eggs is chasing these funds …”
  • “Investors poured a record $110.7 billion into these vehicles during the first nine months of 2006 -- more than twice what they did in all of 2005.
  • So many hedge funds have crowded into the markets that the industry is struggling to generate standout profits. As of Sept. 30, the average hedge fund was up 7.1 percent in 2006. Investors would have made more money buying a mutual fund that tracks the Standard & Poor's 500 Index, which returned 8.5 percent through September.
  • And while hedge funds typically charge a fee of 2 percent of assets and take a 20 percent cut of profits, the Vanguard Institutional Index Fund charges expenses as low as 0.025 percent of assets.
  • Investors are coming to grips with slackening returns. At the California Public Employees' Retirement System, Senior Investment Officer Christy Wood says hedge funds may have a hard time hitting her investment goals because of a rise in U.S. Treasury yields. Calpers, which has invested about $4 billion in hedge funds, targets a return of 5 percentage points more than T-bill rates. In 2003, that figure was 6 percent. On Nov. 8, with T-bills yielding 5.1 percent, it was more than 10 percent. "It doesn't take a lot of research to realize that you're going to have a harder time reaching that today,'' Wood says.
  • Hedge Funds

    The remainder of the article discusses new areas that hedge funds are exploring in their search for improved returns. Actually, most of the areas discussed are not new to hedge funds so it’s just a review of what areas are relatively hot: emerging markets, distressed securities, event driven, activist funds, etc.

    The End of the 'Alpha-Centric' Mentality?
    Based on the points listed above, perhaps we’re seeing the large hedge fund “conglomerates” understand and acknowledge the reality of “hedging their bets” (sorry). Hence, the recent press from the Financial Times regarding Goldman Sachs (NYSE:GS) and their entry into hedge fund replication strategies.

    This is an interesting development since, according to the same Bloomberg article above, Goldman Sachs is “ … the largest manager of hedge fund money, with $29.5 billion in assets …”

    On the one hand, a firm like Goldman Sachs must be in the business of alpha, that rare commodity which is based on a manager’s ability to provide something beyond what the broad market itself can provide. Heck, they personify alpha when you consider what they supposedly know and the money they make.

    The use of a program to replicate hedge fund strategies deviates from this “alpha-centric mentality” and suggests that the costs of highly active management are now making a significant impact. Clearly, institutional investors are demanding a true assessment of the costs of active management. For those who conclude that the costs they pay for something (alpha, diversification, access to niche managers, whatever it is they think they’re getting) are too high, we are seeing the industry’s attempt to respond.

    I only wonder how GS and other entrants in this specialized area will market replication strategies. Will they add it to existing multi-manager hedge fund programs in an attempt to lower overall costs for the mandate? The FT piece claims that GS is charging a flat 1 percent fee. Are costs a consideration, but secondary to the attempt to achieve better, or specifically, more optimal programs to compliment a client’s core portfolio?

    Is liquidity and transparency the bigger issue? According to the article it will be far more liquid, with trading available on a daily basis.

    "This may be ideal for any large institution that has been looking at hedge funds but doesn’t like the fact that it takes six months to put money [in] and to take it out again,” said Edgar Senior, executive director in Goldman’s fund derivatives structuring team.

    With all of these enticing attributes such as low cost and liquidity, my final question would be what’s stopping Goldman Sachs or someone else from building an ETF based on the underlying Absolute Return Tracker index? Nothing I suppose. One of the big problems in the hedge fund industry, especially with the “retailization” of hedge funds is the relative high level of expectation versus actual performance in aggregate. For ordinary investors getting into a hedge fund ETF, my fear is that this trend would continue.

    Bottom line: It is way too early for me or anyone to make any conclusions based on recent developments. Hedge fund replication strategies require enormous resources in terms of checking “under the hood”. I hope to focus quite a number of future entries on this emerging area.