By Harry Liem, a senior consultant and Dragana Timotijevic , Head of Alternatives Research for Mercer’s investment consulting business.

The concept of ß and indexation in traditional asset classes has been well accepted, and indeed has been shown to account for the majority of the returns for traditional portfolios. This concept has not been applied to hedge funds yet, as these funds so far have been marketed as predominantly alpha oriented strategies. With increased realisation that hedge funds derive a significant portion of the returns from market exposures, there has been a greater focus on trying to capture the so called hedge fund beta through replication (linear or non-linear) and indexation. Cloning and indexation are often touted as the most liquid, transparent and low cost alternatives for gaining exposure into hedge funds.

Linear replication consists of taking long and/or short positions in a set of factors that best explain the performance of a fund or an index in the same period and passively holding them in the out-of sample (or verification) period with the periodical rebalancing. Most investors who obtain exposure to hedge funds do so for the reason of obtaining pure alpha orthogonal to traditional beta, which is certainly not the case with the linear clones. Also, linear clones may not be worth charging 100 basis points for future trading positions that investors could easily replicate at a much lower cost. Furthermore, given our analysis of the likely performance of linear clones during times of crises, linear clones may be less suitable for replicating hedge fund performance.

As a counter to these arguments, some clone development has taken place in favour of more active non-linear forward looking clones. These are based on trading rules, emulating not only mean and variance, but also skewness, kurtosis, and beta as some hedge fund strategies are typically asymmetric in return profile. One of the caveats against investing in these active clones is the fees they charge, e.g. 1.5% + 15% performance (without hurdle). This is not too dissimilar from a standard active single manager multi-strategy operator, and industry observers are well aware of the hurdles multi-strategy managers face when trying to obtain multiple streams of uncorrelated alpha sources. Also, as the design and quality of the strategy - trading rules - become the essence for the active clone performance, we fall back into the domain of active management.

A lively debate has also evolved around the merits of hedge fund indexation, as a number of investment banks are offering index tracking products, by investing in a subset of the active managers, whereby they gain access to managers otherwise closed to other investors on account of their relationships or use proxy managers. This delivers exposure to hedge fund indices, which are a mix of alpha and beta. So far, empirical evidence from the clones with a longer track record (around two years) is somewhat limited and has shown a mixed performance. This is in spite of the bullish equity market conditions that existed since 2003. Indexation on the other hand has a somewhat longer and successful live history (five years), though the capacity to track the broader index will depend on a manager’s future ability to access to closed managers. Furthermore, the fee gain is relatively limited, as the index manager will still charge 100 bps on top of the 2% plus 20% paid to the underlying managers.

The interest in alternative beta strategies has stemmed largely from the high fees charged by hedge funds for a return stream that represents a mix of beta and alpha. It represents a shift in industry thinking from asset classes to alternative beta and pure alpha strategies. The body of evidence seems to conclude that we will be thrust into a dual world with low cost, passive beta providers on the one hand, and high cost pure alpha providers on the other hand. Passive hedge fund investing may serve to put some pressure on hedge fund fees and also disentangle the true alpha generating managers from their more average counterparts, both of which are commendable objectives by themselves. They will also probably foster more research work in obtaining different alternative betas. Non-linear clones may be able to deliver a viable alternative for clients and, at the same time, provide further impetus for the trend towards low cost beta and high cost alpha. However, at this stage, the costs and constraints of obtaining beta through both cloning and indexation may not yet outweigh the potential benefits, especially in less efficient asset classes such as hedge funds where there is still a somewhat higher dispersion and persistence of successful managers.

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© 2008, Mercer Human Resource Consulting Pty Ltd

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