Andrew Lo: Hedge fund replication is an “elegant solution in search of a problem”

Day Two of Terrapinn’s annual “Alternative Beta and Hedge Fund Replication” conference in New York kicked-off this morning with an appeal from MIT’s Andrew Lo for hedge fund managers and hedge fund “replicators” to lay down their weapons.   As he wrote in a recent article on the topic:

“…hedge fund beta replication is neither better nor worse than direct investments in hedge funds-it is simply different because replication strategies trade off the full return of hedge funds for improved transparency, liquidity, capacity, and fees.”

Thinking of firing your hedge fund manager for being long Lehman?  No worries, argued Lo.  You can use hedge fund “clones” as a transition tool so you can maintain your exposure to their strategy while you search for another manager.

Have to invest $3 billion in hedge funds quickly and the best hedge funds are all closed to new investments?  Again, no worries.  Lo told the audience this morning that hedge fund replication products are a valid alternative even though they lack the alpha of the world’s elite managers.

In other words, argued Lo, hedge fund replication addresses investors’ extra-economic needs.  While they may not provide true alpha, they remain an elegant solution that just needs to applied to the right problem.

“Remarkably Resistant”

While many academics and practitioners have come to accept the importance of bifurcating alpha and beta, another speaker here today provided an explanation for why so many others have not yet joined the alpha-centric revolution.

Larry Siegel, the Director of Research for the CFA Institute’s Research Foundation (and Director of the Research at the Ford Foundation) observed that:

“…the investment management industry has proved to be remarkably resistant to learning from what we broadly term modern portfolio theory.”

Siegel, who is always a crowd favorite for his frank and honest commentary on the asset management industry, also provided a great anecdote to show why hedge fund managers may not be paid enough.  (Not a typo – He wondered if hedge fund managers are paid enough – and bear in mind that he is an investor, not a manager.)

Imagine if you had a business idea and you went to a bank for a loan to start things ups, said Siegel.  The bank refuses to lend you the money so you start shopping your idea around to various VCs and angel investors.  Your idea has merit and eventually Joe Angel Investor offers you $1 million.  Great, you think.  But then Joe asks for 80% of the company in return.  You are willing to give Joe some stock, but are insulted that he expected you to hand over four-fifths of the business in return.  After all, without you, there IS no business.

It’s quite reasonable, mused Siegel, that you should expect to retain more of the upside for your ideas than this.  Yet hedge fund investors balk at the “20 percent carry” in hedge funds.

While the analogy isn’t perfect, it does raise interesting questions about how the spoils of a successful hedge fund investment are shared, and it may also explain why institutions are generally thought to be less fee sensitive when it comes to performance fees than they are when it comes to management fees.

Speaking of Fees…

Many of the sessions at this event seemed to return to one common theme: fees.   In Business 101, we are taught that prices are usually set on the basis of cost or demand.

When the cost of a Bloomberg terminal falls, hedge fund managers tend not to drop their fees, and when labour costs rise, fees do not rise.  So it’s safe to say that in the short and mid-term hedge fund management fees are not based on input costs.

When demand for hedge funds increase – as they have for much of the past 15 years – prices do not seem to rise.  Even when demand seems to be rising faster than supply, the tried and true “2 and 20” remains relatively unchanged.  Further, as demand leveled off over the past year, prices showed only modest downward pressure.  So hedge fund fees also don’t seem to be directly linked to market demand either.

Instead, prices may ultimately end up responding to what is established as “appropriate” given the theoretical efforts required to deliver each strata of returns: next to nothing for equity beta, 1-2% management fees for alternative beta, and a performance fee for alpha.  At least, this seems to be the emerging consensus when you talk to leading academics, investors and managers.

The question is, however, will the marketplace ever finally force such a logical pricing scheme into existance? Perhaps.  Perhaps not.  But there is definitely a growing dissonance between what industry thought leaders are espousing and what the market equillibrium is actually producing.  To borrow from John Maynard Keynes, the attendees at gabfests such as this are aware that “the market can remain irrational longer than they can remain going to conferences.”

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