Surprising Results From Hedge Fund Replication Survey

The results are in from a global survey on “hedge fund replication” and you may find some of the results a little surprising. The sample of 180 hedge fund managers, investors, consultants and service providers reveals, for example, that hedge fund managers now see so-called hedge fund clones as a complement to their offerings – not a replacement. The survey was conducted jointly by AllAboutAlpha.com and conference producer Terrapinn over the period of January 29-February 6, 2008. What follows is a more in-depth look at the findings.

Respondents to this survey represented a cross section of the hedge fund industry from single manager hedge funds to end investors – allowing for some interesting comparisons across segments.

Skeptics of hedge funds often argue that they produce little to no real alpha (see one such example in a recent posting). So to get an idea of the ideological views of the end investors and consultants we first asked them if they attributed hedge fund returns to “manager skill” or to simple risk premia.

While end investors and consultants each seemed split on the issue, end investors were more likely to “strongly agree” that hedge fund returns are mostly the result of skill. Conversely, consultants were far more likely to “strongly disagree” with this assertion.

While a small portion of end investors were currently invested in hedge fund replication products, nearly three quarters of them were familiar with the offerings. Overall, a third of respondents planned to invest in these products by the beginning of 2009…

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Sample end investor comments:

• “We’re interested!”
• “It (hedge fund replication) is ridiculous!”
• “I’ve built my own internal model to understand exposures. It’s been very revealing and provides a second dimension of risk that can be applied to entire portfolio alpha.”

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So why the interest? We asked respondents which aspects of hedge fund replication products were most attractive. End investors seemed most attracted to their liquidity – with lower fees coming in a distant second. When asked to hypothesize why their clients were attracted to these products, asset managers felt that liquidity and fees were of equal importance.

When asked why they were not planning to invest in hedge fund replication products, end investors identified the fact that these products “only replicate hedge fund averages”, and that they “don’t know enough about the theory and products” as their key concerns. None of these end-investors identified performance or fee-levels as reasons for their decision.

While hedge fund replication was originally seen as a way of avoiding the purchase of regular hedge funds (see related posting), many hedge fund managers now seem to view these products as complementary, not competitive. In particular, funds of hedge funds and traditional “long-only” managers were more likely to view hedge fund replication offerings as complements. Consultants viewed them as slightly less complementary and hedge funds themselves viewed these products as competitive.

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Sample asset manager comments:

• “Fees for risk adjusted returns from these products will go down. Then fees for better risk-adjusted return products will go up as they will be able to further differentiate themselves.”
• “The risk in attempting to create a passive product for what is an active discipline proves that investors don’t understand the true risk characteristics of what they own.”
• “Dynamic factor models may prove useful as an ex-post tool for understanding what drove the markets at different times.”
• “In the end, hedge fund replication will probably end up replicating the ’alpha’ of hedge managers that don’t really have much, if any, alpha.”

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When asked how these asset managers were actually using hedge fund replication products, many saw them as a tool to augment investments in traditional (i.e., “active”) hedge funds in portfolio construction.

We asked all respondents what they felt were the best uses for alternative beta and hedge fund replication products. Funds of hedge funds and traditional managers seemed most interested in the potential to create new products with them. Hedge funds themselves felt that these products might be viewed as a benchmark. And consultants seemed the most divided on the most important benefits of these hedge fund replication products. Notably, no fund of fund respondents listed “setting hurdle rates” as a major benefit of hedge fund replication.

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Sample consultant comments:

• “I do not believe alpha can be easily replicated without manager skill.”
• “Do they really work in times of market shocks? (e.g. SocGen sell-off)”
• “Replication is here to stay and is just the tip of the iceberg.”

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Finally, we asked all respondents how they felt hedge fund replication and alternative beta products would impact the asset management industry. Traditional “long-only” managers felt that these developments would impact hedge fund fees the most. Consultants felt the advent of these products would impact transparency the most. Hedge fund managers themselves seemed to feel that these products would lead to a greater understanding of hedge fund returns while funds of hedge funds showed a slight bias toward both fees and an understanding of hedge fund returns.

What emerges from this survey is a chaotic and sometimes counter-intuitive picture with only modest consensus on the question of whether hedge fund replication represents a threat or a way forward for the industry. Likewise, there is little consensus on the best use for these products and on their lasting effects. One thing seems certain, however: hedge fund replication has galvanized the debate about what is and isn’t “true alpha”.