Hedge fund clones

The Economist discusses some proposals for cheap replication of hedge fund strategies. The first paper mentioned below is by Andy Lo of MIT. Recent innovations like ETFs and other narrowly focused instruments allow cheaper exposure to well defined types of risk -- the cost of placing a bet on a particular strategy is lower than ever before. However, this begs the question of how one decides which bet to make, and when. I don't think the difficult part of generating alpha is the mechanics of making an investment (at least, not anymore), but rather the decision making.

Economist: ...But financial scholars are beginning to demystify hedge funds. They think they can replicate their performance using garden-variety financial products. The result could be a cheap competitor for the hedge-fund titans, akin to the index-tracking funds that have eaten into the market shares of active fund managers.

Replication is possible because hedge-fund managers are not as distinctive as they claim. They say their returns are based on skill, or “alpha”, but in fact their performance is largely derived from market movements. A recent paper* by two academics at the Massachusetts Institute of Technology breaks down the returns of 1,610 funds from 1986 to 2005. It finds that six common factors, such as the change in the S&P 500 index and the return on corporate bonds, explained a significant part of hedge-fund returns.

Investors can gain exposure to these factors through widely available liquid instruments. Thus it should be possible to build “clone” portfolios that resemble hedge funds. Such portfolios would not only avoid hedge-fund fees, but would also escape the risk of backing a mismanaged fund, such as Amaranth, which lost 65% of its value in September.

The authors suggest cloning a fund by dissecting its performance over the past year or two. One could sift and sort the factors behind its success, and allocate the clone's money accordingly. A back-tested clone portfolio returned an average of 12.8% a year over nearly 20 years compared with 14.2% for the typical hedge fund. And the copycat portfolio offered investors many of the same benefits of diversification as the fund it mimicked.

Not every academic is impressed by this approach, however. Harry Kat, at the Cass Business School, says that such “multi-factor” models fail to explain a large proportion of hedge-fund returns. But Mr Kat proposes his own cheap alternative†. It may be impossible to know the particular plays hedge-fund managers make. But, he says, you can devise a formulaic trading strategy in the futures markets that would duplicate the overall shape of their returns. His strategies would give investors two of the three things they look for from a hedge: a low correlation with their existing portfolio, at a level of volatility they can tolerate. The return would be out of their hands, but tests suggest profits can be decent: 10% a year in one example.