Synthetic Funds and the Mongolian Barbeque

By: Harry Kat & Helder Palaro, Cass Business School, City University London
Published: August 7, 2006

As we’ve recently noted, one of the spiritual leaders of the emerging “hedge fund cloning movement” is Professor Harry Kat of the Cass Business School at City University in London.

Professor Kat has written a series of papers in the past 2 years that detail a proposed hedge fund cloning process. He has been particularly prolific in 2006 when (so far) he has posted no less than 7 papers to the Social Science Research Network, an international clearinghouse for academic research. Recently, this research was mentioned in both the Economist and Newsweek.

We’ll spend some of this week discussing Kat’s papers – which amount to a sort of trilogy of hedge fund factor analyses. In their first paper, Kat and co-author Helder Palaro propose a hedge fund factor analysis methodology to uncover true alpha. In their second, they apply this methodology to nearly 2000 hedge funds to assess performance.  And in their third (discussed below), they show how this analysis technique might be used to clone hedge funds.

With an apparent nod to The Spice Girls, Kat and Palaro penned a working paper earlier this year called Tell Me What You Want, What You Really, Really, Want!. In this paper, the authors test their synthetic hedge fund replication ideas.  The abstract:

In a set of four out-of-sample tests over the period March 1995 – April 2006 we show that the Kat and Palaro (2005) strategies are indeed capable of accurately generating returns with a variety of properties, including negative correlation with stocks and bonds and high positive skewness. Under difficult conditions, the synthetic funds also produce impressive average excess returns. Combined with their liquid and transparent nature, this confirms that synthetic funds are an attractive alternative to direct investment in popular alternative asset classes such as (funds of) hedge funds, commodities, etc.

In a non-technical summary of this paper entitled Synthetic Funds and the Mongolian Barbeque Kat and Palaro compare portfolio construction to the construction of an entrée at a local London restaurant near Kat’s home in London.

They argue that the synthetic hedge fund approach has been systematically overlooked by the investment community.

Modern risk management techniques make it possible to obtain virtually any desired risk profile by dynamically trading traditional assets such as cash, stocks, bonds, etc. This means that investors do not necessarily have to venture into the great unknown of alternative investments to find new diversification opportunities.

Kat and Palaro acknowledge that, by definition, their synthetic replication strategy does not produce alpha.  After all, it relies solely on passive investments and is, in itself, a passive strategy. (ed: notice how the clones from science fiction movies also seem to lack that je ne sais quoi).  However, they point out, the lack of (volatile and questionable) alpha can be mitigated by the addition of (guaranteed) management fee savings.

Because of synthetic funds’ mechanical nature, however, investors can do without expensive managers. Given the level of fees in alternative investments, this means that although pre-fee returns may not be superior, after-fee returns might very well be. Synthetic funds generate alpha by efficient risk management and cost control, while real fund managers do so by trying to beat the market. Cost reduction is a sure thing, beating the market, however, is not.

So when you compare the risk adjusted returns from the missing alpha to the incremental fee savings, the savings may very well come out ahead. This rings especially true when you consider that aggregate alpha is zero-sum.

Kat and Palaro appeal to out sense of logic by asking a rhetorical question,

why painfully piece together a suboptimal portfolio if the optimal portfolio can be obtained in one easy scoop in the form of a synthetic fund?!

…and in conclusion, acknowledge the inertia which can often define the investment community:

“…investors will need time to come to grips with the concept, but given these benefits, there is no doubt synthetic funds have a bright future ahead of them.”

Read Full Paper Synthetic Funds and the Mongolian Barbeque
Read Full Paper Tell Me What You Want, What You Really, Really, Want!

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