There was a lot of press coverage this past week on City University London's Professor of Risk Management and Director of the Alternative Investment Research Centre at the Cass Business School Harry Kat and his recently published papers on replicating hedge fund performance by way of trading futures contracts.
I first mentioned this new area of hedge fund replication programs, referring to Kat’s site, from which you can download all his papers, on Seeking Alpha earlier this month. Although there are not very many participants in this area, we are seeing quite a bit of scholarly research, and, like with Kat, we should be seeing the evolution from academic papers to actual investment products/services based on this research. MIT professor Andrew Lo, another researcher in this field, is covered in a separate article, and the concept has even gained broad media exposure from The Economist.
So what is this all about? We are in a world where there are many hedge fund products managed by many hedge fund managers. It’s possible that the hedge fund universe is getting so crowded that there is just not enough good performance to go around. With relatively low barriers to enter into the hedge fund industry, just how much “alpha” is out there, on average, considering the large number of participants? And will the trend of more assets going into a larger number of hedge funds continue? Consider Hedge Funds For Dummies, now online, available to any soon-to-be hedge fund investor. I’m just happy to see that How to Create and Manage a Hedge Fund: A Professional's Guide is not ranking as high.
Playing the piano, mastering a martial art, starting and running a hedge fund … clearly there are many activities where a book may be helpful, but is not the way to go. In such cases proficiency is nice, but what you really value is an expert.
Getting back to replication strategies. Like I said, you can’t just rely on what’s written on paper. Kat’s papers, as well as those from other researchers [Lo, Jaeger, etc.], provide various statistics as part of the argument to validate their work. But the proof is in the pudding so what we’ll need to see is some form of real, live performance. In the case of Kat and his associate, Helder Palaro, they have developed a software program called “FundCreator" which, according to the recent articles, is now being used by a small number of institutional investors. It is with this program that investors have the means to build portfolios based on Kat’s research. According to Kat:
“In most cases, managers aren't good enough to make up for the massive fees that they charge. The combination of excessive fees and minimal opportunity in the market makes alternative investments really doubtful in terms of their value for portfolios.”
Kat might not be expecting many greeting cards from the hedge fund community in December. His FundCreator program costs 3 basis points per month for what he calls “the ideal diversifier”. Essentially, through broad beta exposures chosen from a list of 78 different futures contracts managed on a highly active basis, the program makes any number of allocation decisions so as to achieve the desired amount of statistical characteristics [correlation, volatility, etc.]. Clearly, hedge fund managers and especially fund-of-funds will argue that their methods are more proven to provide truly exceptional return characteristics. Like mutual funds, however, the argument always leads to the effect on performance due to high fees. Will replication strategies provide significantly improved performance numbers versus actual hedge fund investing because of its actual investment process or its lower fees or a combination of both?
Reading the various articles above gives you the broadest ideas of what these replication strategies are all about and what I have written here is too short and broad. The academic papers on the internet are generally full of math, except for those from Kat. However, to get a better and more complete understanding of this new concept and how it can be implemented in a real portfolio, I think you need to hear it straight from the source. For those able to get to London on February 12-14, 2007, this HF conference may be of interest. Harry Kat, as well as pretty much everyone [it’s a very small, very niche field at its very earliest stages] in this space, will be speaking at this event.
I have referred to the following blog in the past but I highly recommend, again, AllAboutAlpha, where AlphaMale covers a lot of this new research on replication strategies.