Merrill Lynch Report: Hedge Fund Replication Avoids Headline Risk

Hedge fund replication has been touted as a way to avoid paying “excessive” hedge fund fees, get better liquidity, and even to achieve higher returns than actual hedge funds. But a new report by Merrill Lynch (MER) makes an argument that hits close to home for many pensions and endowments.

The report says that hedge fund replication is a way to avoid headline risk (see HedgeWorld premium story reprinted here with permission).

Funds of funds managers, this is targeted squarely at one of the key planks in your platform: career survival. While it’s not a huge leap from other elements of the hedge fund replication value proposition (e.g. “better liquidity” or “transparency”), it suggests that replicators may be making a more direct assault on funds of funds.

But before hedge fund replicators and funds of funds pick up and move to separate gated communities and join separate country clubs, we thought we should have a look at the report. (Apologies to all of our readers for referencing a pay-per-view report - which is not something we like to do - but Merrill put the kibosh on freebie research back in March.)

The report was produced by Merrill’s Pensions & Endowments Group and makes liberal use of data from Pensions & Investments and Casey, Quirk (so regular readers will be quite familiar with it). It covers three strategies: swaps (apparently in relation to portable alpha strategies), commodities and hedge fund replication.

The report cites Casey, Quirk’s finding that headline risk is one of the key “impediments” to investing in hedge funds (chart from original Casey, Quirk report below).

The "solution", says Merrill is replication (namely, factor replication). Says the report:

For investors wishing to dip a toe in the hedge fund waters for the first time, the replication strategies may serve as an effective transition tool to gain broad hedge fund exposure. As plan sponsors get more comfortable with hiring hedge fund managers (ie, governance procedures in place) these strategies can also be used as a benchmark to measure the success of the new hedge fund manager.

But as the report acknowledges, replication comes with its own set of risks. In fact, naysayers suggest that hedge fund replication offerings are themselves just quant hedge funds.

And while headline risk, transparency and fees are key reasons why some institutions have not yet invested in hedge funds, the issues faced by current hedge fund investors are quite different. The aforementioned Casey, Quirk report also said that the source of returns and performance records were the leading decision criteria (chart below). Notably, transparency and fees came last.

So it seems that while the amelioration of headline risk via replication may pave the way for new institutions to move into this space, funds of funds may still have the upper hand when it comes to new assets from existing investors.