You don’t need a Ph.D. in physics to understand hedge fund replication. But Lars Jaeger has one just in case. And he used it masterfully today to draw an analogy between the model of the atom in the 19th century (a random mass of various particles) and the common paradigm understood today including a nucleus (containing most of the atom’s mass) and a number of electrons orbiting it. Until now, he argues, hedge funds have been viewed as a random mass of alpha, beta and error terms. But a new paradigm is now emerging that aggregates betas into a nucleus orbited by various alphas. The same could be said for active long-only investing in our view. Until now, long-only management has also been a mass of alpha and a set of betas (dominated by market beta).
Jaeger’s Partners Group has developed replication portfolios to mimic the performance of various hedge fund strategies. The returns of these replication portfolios actually beat all hedge fund strategies except distressed (which, according to Jaeger, contains a lot of alpha and is therefore difficult to replicate). Jaeger says that long/short managers, on the other hand, are particularly susceptible to replication.
Jaeger’s research shows that the correlation between hedge funds and their underlying factors differs depending on the fund’s volatility. For example, there could be one correlation value when the market is down and another correlation when the market is up.
Emphasizing the link between hedge fund returns and market volatility, Jaeger says it’s no surprise that hedge fund returns have fallen in the past 5 years since global risk premia have also fallen. But later in his presentation, he also showed that alpha itself has fallen over this period. While this double whammy doesn’t bode well for hedge fund investing, Jaeger holds out hope in the form of hedge fund replication. Even if it turned out that most hedge fund returns were all beta, he suggests, there is still a compelling case to be made for investing in disparate alternative betas based on diversification grounds alone.
In addition, he points out, investors would save on fees by investing in alternative betas (vs. regular hedge funds). Obviously, investors would pay lower management fees. But they also wouldn’t have to sell an under priced option to the manager in the form of an asymmetrical performance fee. Furthermore, investors wouldn’t have to pay the fee arising from the drag caused by un-invested cash kept as collateral by most hedge fund strategies.
Jaeger’s firm manages an $850 million fund he describes as not just the only, but the largest hedge fund replication program in the world. It aims to replicate 18 hedge fund strategies and focuses on tactical asset allocation among these strategies.
Jaeger concluded his presentation by once again drawing on his background in theoretical physics. Hedge funds, he says, are complex molecules. And hedge fund factors can be viewed as the atoms contained within these molecules. Using Jaeger’s analogy, it seems that we have indeed ushered in a new atomic age in asset management.