Special Guest Posting by: Tammer Kamel, Iluka Hedge Fund Consulting
If hedge funds are market wizards, then hedge fund clones are muggles (non-wizards) looking for Hogwarts. Thus far they don’t seem to have found it or the chamber of alpha, but their efforts are nonetheless valuable to investors.
Hedge fund replication is not wizardry at all of course, it is an elegant application of quantitative finance which I find intriguing, albeit for the wrong reasons. The right ones are, presumably, the prospects of a hedge fund product at a lower cost, with more transparency, more scalability, more liquidity and better risk management. This is all desirable of course, providing the clone actually achieves my return expectations. But this is where I have a problem. My return expectations are incompatible with current replication technology. The cloning techniques I have thus far encountered aim to emulate what hedge funds actually do as opposed to what they are supposed to do. This is a consequence of taking the performance of the hedge fund collective as their replication objective. But the performance of the collective, or equivalently the average hedge fund, is actually not good. Thus replicating the average hedge fund is no use to me since the average hedge fund is a bad investment.
I would be intrigued by hedge fund replication if a D.E. Shaw clone arrived on the scene. I would even be excited by a replication technology which reproduced the performance of the top quartile of hedge funds. But neither of these seem likely to appear.
In spite of this problem, I am in fact intrigued by this new science because, firstly, the exercise of replication is invaluable in revealing the true nature of hedge funds and secondly, the mission of replication is forcing investors to ask themselves just what it is they want from their hedge fund investments. This is a much needed tonic.
On the first point, it is interesting to note that the progress made on replication should not lead investors to boldly cross from hedge fund to clone. In fact, the success of clones should be driving money out of the space completely. Take for example Professor Lo’s conclusion that a large fraction of hedge funds’ returns can be explained and indeed replicated by a set of passive, traditional investments. This is not a revelation that should make anyone excited about hedge fund clones. It should actually dissuade investors from using hedge funds at all. After all, if hedge funds are ultimately delivering beta, surely the wise investor can dispense with the hedge fund (and its clone) entirely and go straight to the beta? For me, the real lesson from this research is that there is no value to the extra complexity and additional risk of using a fund for simple beta.
On the second point, Professor Harry The Replicator Kat quite wisely challenges investors to ask themselves what they “really really” want. But he takes the fact that so many of them are committed to a gaggle of alpha-incapable managers as evidence that all these investors could possibly desire from the their hedge fund portfolio is a mutated risk/return profile. He thus offers them precisely that. The problem here is that investors, in spite of themselves, do want the hedge fund dream. They just don’t know their not getting it. The challenge for distribution based replication will be to coerce investors to rationalityâ€”that is, to value correlation and positive skewness over fat beta returns. Professor Kat and any competent portfolio engineer will tell them that this is the real route to investment success, but the problem remains that, in my 12 years in the industry, I have yet to meet an investor demanding better kurtosis from me.
The wizardry of a good hedge fund is and always has been alpha. The fact that most can’t produce it, is no reason to excuse clones from seeking it. If cloning alpha is impossible then cloning is futile. But there are replication techniques that are beginning to attempt to clone actual strategies instead of just the mediocre performance of the hedge fund collective. Perhaps there is room for hope that I might one day be intrigued for the right reasons.
– T. Kamel, August 1, 2007
(Ed: Kamel has penned a great primer on the work done by Lo, Kat and others. It includes some axioms that investors should think about when considering replication and it expands on the commentary he touches on above.)