Will “hedge fund replication” benefit from new short selling bans?

At a conference on “alternative beta and hedge fund replication” here in New York today, attendees debated questions such as: What is hedge fund beta? What do institutional investors want from hedge funds and has this changed? and Is 2& 20 at risk?

But the elephant in the room was the question of what will happen now that so many short positions – the bread and butter of the hedge fund community – are no longer executable in many parts of the world?  The ban on short-selling seems to be snowballing as various jurisdictions slam the door in an effort to avoid becoming the last place on earth to short financials.  (For a great run-down of the current situation in various countries, see this post at FT Alphaville).  As one attendee here told me today, “This could be spell the end for hedge funds – at least in the short term”.

Will these new constraints on short selling breathe life into the recently anemic “hedge fund replication” business?  If institutional investors begin to steer clear of hedge funds but still want to tap into their unique return distributions and lack of correlation to equities, then we may be on the verge of a renaissance for these funds.

As attendees stayed glued to their Blackberries for news of the Fed buying, say, GM, the New York Giants, small African countries or the North Atlantic Ocean, debate ensued regarding a topic that was introduced with such fanfare 2 years ago, but has yet to fully realize its potential.

Tobias Moskowitz, a professor at the University of Chicago and consultant to AQR Capital kicked things off here at the Princeton Club of New York with a warning about “beta creep”.  Moskowitz told the audience that the hedge fund community has essentially been forced into adding equity beta to their portfolios since clients like the higher volatility, but want “reasonable leverage”.

Euro Invasion

Eric Valtonen, the CIO of AP3, part of Sweden’s public pension system (see previous AAA guest contribution), gave an update on the reorganization his plan undertook this summer in order to physically divide the management of alpha from the management of beta.  Valtonen said that even his long-only managers are now paid using a performance fee that specifically rewards alpha-generation without paying managers for delivering (cheap) betas.

Valtonen’s co-panelist, Pranay Gupta, the deputy CIO of one of the UK’s largest life insurance companies, Pearl Group, echoed remarks he made in London last spring (see related post) by suggesting fees were actually a critical enabler of alpha/beta bifurcation.  Gupta said that an alternative beta hurdle rate would ensure that investors paid beta fees for beta returns and alpha (performance) fees for alpha returns.

Due perhaps to its powerful pension fund community, Europeans seem to be setting the agenda on many alpha-centric issues ranging from evolving organizational designs to innovative fee structures.  Aside from Valtonen and Gupta, Nicola Ralston, the former Chair of the CFA Society of the UK and Ludger Hentschel of Investcorp also addressed the gathering.

“Washington Lies”

Thomas Schneeweis (see AAA interview), says that academia is the ultimate entrepreneurial business.  And it’s hard to argue against that when you look at his own CV.  Schneeweis is a university prof, the Director of the Center for International Securies and Derivatives Markets (CISDM), the founder and editor of the Journal of Alternative Investments, a founding board member of CAIA, a consultant, and a principal in not one, but two asset management firms.

He told the audience today that there were “lies” – where you know you are lying, and there where “Washington lies” where the other person knows you are lying and you know they know – yet the lie persists.  Unfortunately, scolded Schneeweis, much of the hedge fund data that we take for granted falls into the second category.  Those that know Schneeweis can confirm that he is a major skeptic of commonly-reported data (see post where he questions monthly, even weekly, hedge fund return data).

One simple example of the subtle biases that creep into hedge funds is the so-called “vintage problem”.  Schneeweis says that analyzing a hedge fund’s performance over, say, a 10 year period will reflect the fund’s market positioning a decade ago – when certain strategies produced positive returns.  But a fund with a 3 year track record might appear to be very different since the strategies that worked over the past three years may have been very different from those that worked ten years ago.  In reality, however, both funds might have been identically positioned over the past 3 years.

Not so fast…

Approaching hedge fund replication as an investor would, Nicola Ralston of consultancy Liability Solutions (see AAA guest contribution) phoned around to most, if not all, providers of hedge fund replication products.  And what she found left her quite concerned.  She was clearly not impressed with various responses she was given by managers of these products and delivered an ear full to the audience here about the lack of transparency of their fees and methodologies.  In addition, she questioned whether any of these products could legitimately claim to “replicate” anything when the dispersion between their returns was 10% or more per annum.   After accusing some of the managers of being “very naughty” with regard to their disclosures, she did acknowledge that the enhanced liquidity and lack of capacity constraints were legitimate reasons to invest in these products.

And so with the short-ban elephant sitting comfortably in the corner of the room, day one of this two day conference drew to a close  – leaving the question of whether it was the end of the world as we know it for hedge funds to tomorrow’s program.  Said one long/short manager on the way out:

“Save yourself, serve yourself. World serves its own needs, listen to your heart bleed. Tell me with the rapture and the reverent in the right – right. You vitriolic, patriotic, slam, fight, bright light, feeling pretty psyched.

It’s the end of the world as we know it.
It’s the end of the world as we know it.
It’s the end of the world as we know it and I feel fine.”

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