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Last week, Deutsche Bank (NYSE:DB) joined the hedge fund replication party with its new "DB Absolute Return Beta Index". While it is still too early to gauge the success of the offering, the company’s press release contains some hints about the way it will be spinning this latest entry in an increasingly crowded field.

The early spin deserves both laurels and darts. Deutsche Bank deserves kudos for addressing a common concern about hedge fund replication offerings - that they only attempt to replicate hedge fund returns after fees. There are those who feel that this might be okay if those suppliers didn’t also attack hedge funds for charging too much. After a landmark event on hedge fund replication in London last winter, one reader wrote us to express several concerns. One of those concerns read as follows:

Just what is being replicated? My understanding…is that (hedge fund replicators) are modeling HF returns net of fees. The utility to the end investor will be the same as if they were paying large fees to a hedge fund manager. The saving on fees does not lead to higher returns to the investor. This has been conveniently overlooked.

Attacking hedge funds as too expensive and then replicating the (after-fee) hedge fund indices is inherently consistent, argues this reader. ”Is it somehow better to pay money to the market (in the form of lower returns) than it is to your manager?”, they essentially ask.

The marketing department at Deutsche Bank is obviously familiar with this push-back and makes a pre-emptive strike in their press release:

The DB Absolute Return Index outperforms other beta replication indices and other investable fund indices because it replicates the return of hedge funds before fees.

(our emphasis)

Stephen Farouze, Head of Fund Derivatives at DB hits the point home when he says the product is “superior to the other hedge fund replication products due to its unique construction methodology in adding back the hedge fund fee structure.”

We look forward to watching the index beat “other beta replication indices” and reporting back to you. If successful, Deutsche Bank deserves laurels for this achievement.

However, the firm’s press release deserves a big fat lawn dart for spinning a common deficiency of factor replication into a strength. Says Deutsche Bank:

Furthermore by replicating fund of hedge fund indices rather than single manager indices, DB ARB is more representative of the whole industry as many of the top tier hedge funds are also captured in these indices.

Research show that replicating broad hedge fund indices is actually far easier than replicating individual strategies. In fact, replicating individual strategies - particularly the hard to pin-down market neutral strategy - is somewhat of a holy grail for the replication industry. In other words, when a simple SPDR is likely to be “representative of the whole hedge fund industry”, who needs complicated products?

For example, this study by Hasanhodzic & Lo finds that the best factor models can only explain a small part of hedge fund sub-strategy returns. This study by Jaeger and Wagner shows that only the long/short, short-bias and event-driven hedge fund strategies can be adequately replicated using factor models. After summing up the spotty track record of sub-strategy replication in a recent paper, Professor Harry Kat hypothesizes:

Since it is essentially dynamic trading that makes a hedge fund, dynamic trading is crucial when replicating a single hedge fund or a basket or index of funds following a similar strategy. Its importance declines, however, when attempting the replication of a more diversified basket of funds. Funds following different strategies will trade differently and their trades may (at least partially) cancel each other out. As a result, dynamic trading becomes less of an issue. It is exactly this phenomenon, which allows Merrill and Goldman to obtain such accurate replication. The HFRI Composite is a basket of over 2000 hedge funds, following a large variety of strategies. Since it is extremely diversified, the peculiarities of the various strategies will largely diversify away. The result is an index with little hedge fund-like properties left, containing mainly equity and credit risk.

It turns out that the more diversified the index, the easier it is to replicate. In fact, as this recent report by US consultant Jeffrey Slocum points out, the 24-month rolling correlation between a highly diversified hedge fund index (Tremont) and the S&P500 has averaged well over 0.5 for the past 10 years and has been about 0.8 for the past 2 years.

So Deutsche Bank’s attempt to be “more representative of the whole industry”, amounts to an attempt at making the best of a very difficult task.

Source: Deutsche Bank Joins the Hedge Fund Replication Party