Fake it or make it? Hedge fund replication and why you should own the real thing

Duncan Moir, Senior Investment Manager - Aberdeen Standard Investments

Like what you see above? What if I said you could take that painting home, hang it on your wall and enjoy owning a Van Gogh for a rock-bottom price?

Well, that’s exactly what hedge fund replication aims to do. It tries to deliver the returns of a complex and expensive industry for a fraction of the costs by mimicking the styles of hedge fund old masters, post impressionists and modernists! The question is, would you rather own the fake, or the real thing?

As investors began to demand exposure to hedge funds at lower costs, savvy fund managers developed cheap alternatives. Their aim? To replicate industry returns in liquid formats. While these products delivered reasonable returns, their construction resulted in tracking errors that clearly pointed to something other than hedge fund returns. Passive benchmark tracking is a potential way of solving this problem. Passive hedge fund tracking aligns the interests of the underlying hedge fund managers with the end clients, creating a more collegial and commercial offering.

Passive hedge fund tracking aligns the interests of the underlying hedge fund managers with the end clients, creating a more collegial and commercial offering.

Differences in philosophy

Hedge fund replicators try to deliver hedge fund-like returns. But they aim to do so with greater liquidity and at a lower cost than investing directly in hedge funds or in funds-of-hedge-funds. Hedge fund replication works by attempting to decompose the returns of a hedge fund benchmark into liquid factors or proxies, and using those proxies to try to deliver the industry return. The decomposition usually comes from either some statistical method – making it an inherently backward looking process – or by bottom-up construction using systematic factors.

Taking a top-down approach might involve methods such as regression, clustering or principle component analysis (PCA). PCA is a way of simplifying complex, high-volume data while trying to retain the patterns within it. With these kinds of statistical replication, managers use a range of tradeable, liquid assets to generate returns as close as possible to the target benchmark. They estimate factor loadings (or exposures) for each asset, which vary over time depending on the returns of the benchmark. The replicator will use the factor loadings as weights to apply to each asset on a rolling basis, the output being the replicator’s return.

These are backward-looking processes because they use prior information to determine the factor loadings. The result of these estimations is an output with a reasonably high tracking error to the hedge fund benchmark. Effectively, they deliver a profile that is not always representative of the hedge fund industry.

Alternatively, those using the bottom-up approach seek to build a representative portfolio with simple systematic factors that replicate each underlying hedge fund strategy. For example, they might use a simple trend-following strategy to replicate commodity trading advisors, or a style-based equity model with a modest market exposure to replicate the equity hedge strategy. This approach makes replication of hedge fund exposures more accurate in that the systematic factors are designed to behave similarly to hedge fund managers. We have seen similar factors used in alternative risk premia. However, they are not a perfect match; they introduce more trading costs than the top-down approach, and they require more complexity.

Sophisticated approaches are all well and good, but would you use them to track the S&P 500 Index?

Aligning interests

Passive hedge fund investing, on the other hand, operates just like traditional market passive investing. Managers of passive funds track a benchmark (e.g. the S&P 500 or the FTSE 100) by investing in each of the underlying constituents. For passive hedge funds, this means investing in each of the underlying pooled hedge funds that comprise the hedge fund benchmark. This approach is forward-looking, in that it gives exposure to the current positions in each manager’s portfolio at that point in time.

Additionally, it matches the interests of the underlying hedge fund managers with the tracker product and end client. This contrasts to replication, which seeks to bypass the hedge fund managers and avoid paying their fees. Aligning these interests can result in underlying constituent hedge funds being more commercial in their pricing for investments coming through passive tracker products. In turn, this means the tracker provider can deliver returns close to the benchmark.

Hedge fund replication is not fine-tuned to the level of master-art forgery. Buying a replica fund may be a lot less ruinous than mistakenly buying a fake masterpiece, but many investors are seeking certainty in an uncertain world. Investing in a passive hedge fund tracker – a vehicle designed to deliver an expected outcome – could be the favoured choice of the shrewd allocator.

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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