Alternative Viewpoints: Being like Jesse James

This is the first of our series of guest articles (“Alternative Viewpoints – powered by CAIA”) written by a member of the Chartered Alternative Investment Analyst Association (CAIA Association).

By: Ryan Teal, CAIA

I was watching TV the other day and an advertisement came on for the movie, The Assassination of Jesse James by the Coward Robert Ford”.  The Jesse James character muses to a young, infatuated Robert Ford, Do you want to be like me, or do you want to be me?

This is what hedge funds must feel like with hedge fund replication.  Until recently investors have been told that hedge fund returns are not properly replicable but what happens if we can not only properly replicate these returns but do so at a significantly lower cost?

Recently I was able to view slides from a Thomas Schneeweis presentation called New Product Development: Replication vs. Indexation, in which he addresses this concept by discussing new replication methods available (such as Factor-based and Security-based replication), the theoretical basis for each and results from their performance against hedge fund returns.

Schneeweis illustrates below that many investors are now finally challenging the notion that hedge funds are not a pure source of alpha but in fact consist of a significant beta, or alternative beta, component.

Likewise Schneeweis points out:

At the portfolio level, Hedge Fund trading strategies involve dynamic exposure to various market factors.

Such exposures are readily modeled using econometric techniques that account for the variation in exposures.

Dynamic replication of the factor exposures of hedge fund trading strategies produces return streams that are highly correlated with existing hedge fund indices.

And he provides the following out-of-sample performance examples:

And finally Schneeweis concludes that:

…the benefits of replication strategies are they can provide: liquidity without adverse performance impact, immediate diversification, transparency and low-start-up (due diligence) costs.

The presentation really makes a good case for hedge fund replication as a low-cost alternative to traditional hedge fund investing.

So then how should hedge fund managers view these new products?  Should they fear them?

No, absolutely not.

Hedge fund replication should be hedge funds new best friend.  Let companies keep rolling out new hedge fund replication products.  Bring them on!

This is an opportunity for hedge funds to finally prove their worth.  They should avoid getting into a mud-slinging contest but instead do what they do best, that is, identify a changing environment and then find a way to use it to their advantage.

Benefiting Growth

A huge source of future growth in the industry is going to come from institutional investors (see related articles), and hedge fund replication solves one of the major problems to attracting these investors: it provides something meaningful against which to measure performance.

Institutional investors place a lot of significance on relative returns, so would it not be better to show these investors how well your fund is doing against something that shares characteristics of your investment, rather than just using the S&P 500 (especially if you are not even invested in equities)?

According to Fung and Hsieh:

Over the past decade, academic research has identified a number of replication strategies capable of capturing between 40% – 80% of the average return of many popular hedge fund strategies (see full report).

And Schneeweis:

Publicly available research shows that between 30%-90% of time series variations of hedge funds can be explained by the replicating portfolio.

By having a better proxy for comparison this will help your investors separate out the good managers from the bad.  This is a good thing, unless of course, you are one of the bad ones.

Secondly, as more companies get involved in the industry the increased exposure and competition helps to address the knowledge asymmetry that exists between hedge funds and investors.

Knowledge asymmetries exist when one party to a transaction has more knowledge than the other party.  This can lead to difficulties in completing the transaction.  For example, I know nothing about cars so when I go to a mechanic and he tells me, you need this part replaced and it is going to cost X amount of dollars, I have no idea whether what he is saying is correct and whether the price I’m being quoted is competitive. All mechanics have more knowledge than I do and this leaves me at a disadvantage. In some cases, if I feel that I’m getting ripped off I may not even go ahead with the repairs.

The degree of knowledge asymmetry can be decreased by increasing the knowledge of the less informed party.  So having a trustee of a pension plan or large corporation become more knowledgeable about hedge fund investing by having firms such as Merrill Lynch, Goldman Sachs and State Street put their research time and resources into hedge fund products will, in the end, only help the industry as a whole.

Evolution at work

Hedge funds and hedge fund replication are like two chapters of a yet unfinished novel.  As Schneeweis illustrates in the diagram below, fund based investing began first and now what we are seeing with hedge fund replication is just another stage in the overall product development.

Change is inevitable.  Those who hold onto how things used to be are going to get left in the past.

The advent of hedge fund replication is evolution at work.  Don’t fight it; embrace it.

Ryan Teal is an analyst with the $12b OPSEU Pension Trust in Toronto where he is responsible for conducting research on new asset class investments, particularly alternative investments. Ryan graduated with a Bachelor of Commerce degree from Ryerson University and holds the CFA and CAIA designations.  Ryan is also a committee member with AIMA Canada.  The opinions expressed by the author are not necessarily those of the CAIA Association or AllAboutAlpha.com.

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