Hedge fund replication is “imitation crab meat” according to major hedge fund company

Apparently, there are different takes on hedge fund replication – as evidenced by the contrasting views of AlphaSwiss Group and Professor Harry Kat.   But a vigilent reader of AllAboutAlpha recently sent us the Q4 investor letter from a prominent fund of hedge funds company that contained a third point of view.  In the letter, the firm makes it quite clear it is not amused by any form of hedge fund replication.

The firm did not return calls to AllAboutAlpha regarding the letter.  But the following excerpt speaks for itself (and wins full marks for creativity):

Imitation Crab Meat is the central ingredient in California Rolls dispensed at discount sushi establishments throughout the world. In December, the US Food and Drug Administration agreed to allow the seafood industry to remove the ‘imitation’ label and instead refer to the product by its catchier moniker, ‘Surimi’. The processed fish was developed after several years of research by Messrs. Y. Sugino and K.Osakai, who devised a multi-factor process to combine cryoprotectant materials such as sorbitol with other texturing agents, flavorants and colorants to replicate the sought-after features of real crab meat.

Coincident with Surimi re-branding, December saw the launch of another cleverly named product: Absolute Return Tracker or ART. After years of research, G. Sachs and M. Lynch independently devised passive hedge fund substitutes (the ART Index and the Merrill Lynch Factor Index). Employing a multi-factor model calibrated to past performance, these tracker products combine volatility swaps, credit derivatives, ETFs and other financial instruments to replicate the sought-after features of hedge funds, namely high risk-adjusted returns with low correlation to traditional markets. Like Surimi, these ART products are cheaper than the real thing. Therein lies the primary benefit – a reduction in fees that would otherwise eat into an investor’s return. Along with this carrot are elements more difficult to digest. For one, these faux hedge funds seek only to be average, an unworthy aspiration in our view since the average hedge fund tends to have unattractive features such as a pronounced beta to the equity market and mediocre risk-adjusted returns. By calibrating to past performance, these morsels are past their purchase before date, in food industry parlance, or optimized to the loser’s game, as Charles Ellis characterized this method of financial decision-making. Finally, these offerings are wrapped in seductive simulated return packaging to entice potential buyers. Though the small print is crafted to be investor-friendly, one only needs to read the health warnings on the back of the label to get a sense of the hazards they could face as a consumer of the product.

In our third quarter 2002 outlook, we discussed another passive hedge fund strategy – Investable Indices:

‘We assert, despite our obvious self-interest, that investing passively in hedge funds is a folly. More specifically, we see passive investing in the sector to be infeasible, a low risk-adjusted return proposition and at odds with common sense.’

We highlighted the MSCI and S&P investable index offerings together with our prediction that they would lead to a high degree of disappointment to those investors opting for the passive approach. A few years after our prediction, S&P investors have found themselves mired in an ugly bankruptcy proceeding with the likelihood that they will receive only a fraction of return of their assets (let alone a return on their assets). We would not be surprised if those investors taking a bite of this apple ultimately suffer a similar disappointment. We have heard through the grapevine that these products are being predominantly offered to retail investors. Perhaps those that gorge on Surimi at the all-you-can-eat buffet have a palate suitable to the taste and texture of these new ART forms.

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