Are Hedge Fund 'Clones' a Fabricated Product?

The trouble with CDOs is that the investment banks had to gather up massive amounts of mortgages and other assets to feed the raging demand. This insatiable demand for assets directly led to lax mortgage underwriting standards and the current mortgage crisis. Now the investment banks are turning to a derivative product that might not require any underlying assets. Instead of turning lead into gold, the new alchemy is to turn something out of nothing.

The Financial Times' "Credit Suisse sets up hedge fund clones" introduces us to a new derivative that mimics the performance of three common hedge fund strategies without the overhead. Hedge funds typically charge 2% of assets, 20% of profits, and could have a long lockup period. The hedge fund clones charge between 1% and 1.2% a year. Credit Suisse (CS) is new to the game, but Merrill Lynch (MER), Goldman Sachs (GS) and Deutsche Bank (DB) have been active during the last 18 months.

The idea behind the product is that the performance of a hedge fund is based on the strategy and underlying assets rather than the skill of the manager. For example, the manager cannot control currency directions. His profit or loss would depend only on the strategy applied to the currencies. Indices currently exist which match hedge fund strategies to assets. Credit Suisse already runs the CS/Tremont hedge fund indices. It is unclear whether there is anything backing the clones (like an ETF) or these derivatives are pure bets.

Disclosure: None