Hedge Fund Replication: A Replay of the ETF- Mutual Fund Relationship?

by: Christopher Holt

In case you don’t usually read the bi-monthly report “Financial Stability Review” from the Banque de France, you might be interested to know that April’s edition (now on newsstands everywhere) is dedicated to hedge funds. A portion of it dealing with hedge fund replication has interesting parallels to the mutual fund industry.

Professors Bill Fung and David Hsieh provide their usual commentary on hedge fund replication for the report (not that dissimilar to their report to the Federal Reserve last year).

But buried in the “state of the industry” treatise is a nuanced argument about the very raison d’etre for hedge fund replication. Essentially, Fung & Hsieh advocate hedge fund replication as a way to keep managers honest. In other words, (cheap) hedge fund replication can and should be used as a benchmark to accurately define true alpha. But ironically, argues the duo, investable hedge fund replication fees have been marked to prevailing hedge fund fees, not the other way around. In their report, they conclude:

Since the early days…numerous innovative trading strategies have been created…(But) despite the differences in risk taken by hedge fund managers to generate profit for their investors, their compensation structures remained remarkably similar across a broad range of investment styles. There is practically a ‘one-size fits all’ formula where hedge fund managers are paid a fixed fee proportional to the capital they manage and participates in the trading profits they generate without any reference to risk. One plausible explanation is that, unlike conventional long-only strategies, the absence of suitable benchmarks – against which the manager’s skill, alpha, can be separated from passive beta bets – makes it difficult to establish suitable performance hurdles that properly reflect the passive component of hedge fund returns. The arrival of HF clones could have a profound influence on how hedge fund managers are compensated. Armed with this alternative way of accessing passive hedge fund returns, investors can point to investable performance benchmarks that separate alpha returns from passive beta bets. Incentive fee contract can now be structured to reward skill, or alpha, differently from passive index-like returns.

The existence of these index-like hedge fund products can also act as catalysts to improve the price discovery process in the hedge fund industry – more efficient fee structure with equitable risk-return sharing between investors and managers. This is in fact a healthy development for the hedge fund industry, one where alpha producers with limited capacity can be sufficiently compensated for their skills and beta-only products will regress to being index-like alternatives at lower fees.

Alas, replicated hedge funds are being offered as an alternative to hedge funds (and priced accordingly), rather than as a way to measure true alpha.

In our view, this is not dissimilar to the introduction of ETFs to the mutual fund industry. Uninvestable indices like the Morningstar style boxes originally helped benchmark managers and determine value-added. But now that BGI manages ETFs based on each Morningstar style box, are we to conclude that mutual funds are toast? Or are we to simply conclude that mutual fund managers ought to drop their fees to a level that is commensurate with the amount of alpha they produce?

Naturally, we believe the latter - that ETFs shine a harsh light on the mutual fund industry, revealing the fee being implicitly paid therein for active management. While this implicit fee was easy enough to calculate prior to the emergence of ETFs, we now have the liquid financial “technologies” required to arbitrage between mutual funds and equivalent portfolios of ETFs & hedge funds. And management fee arbitrage puts downward pressure on mutual fund fees.

But while ETFs can go a long way toward isolating true added value and the fees charged for it, they don’t actually tell us the fair market value for that embedded active management. However, there is an established market for “active management” - hedge fund investors have been paying for “high-alpha-proportion” funds for years (assuming for a moment that hedge fund alpha is actually alpha). It turns out that the active management in many mutual funds is priced higher than the analogous active management sold as a bona fide hedge fund(!)

Unfortunately, no such market for “true alpha” exists against which we can benchmark the (ex-alternative beta-) hedge fund fees. So we are stuck with the fees implied by a hedge fund’s proportion of (cheap) alternative beta. With hedge fund fees running at, say, 4 or 5% (all-in) and alternative beta explaining over half of their return movement, that fee will almost certainly be higher for that totally unreplicatable je ne sais quoi.

This type of analysis has already been conducted on the mutual fund industry and it will only be a matter of time until it will be conducted on hedge funds - once investable alternative betas become ubiquitous.

How do you say “deja vu” in French?