Since hedge funds first captured the imagination of investors, efforts have been afoot to replicate their performance using passive investment techniques. So-called “hedge fund replication” seemed to have it all – low costs, similar performance, liquidity, & transparency – but as the number of “replicas” exploded, many eschewed their original objective of replicating the hedge fund industry’s performance. Instead, funds began to compete with each other on the basis of performance and risk. If minimal tracking error was the main objective of these funds, then out performance, no matter how large, could be viewed as a failure.
A recent paper by Nils Tuchschmid & Erik Wallerstein of the Geneva School of Business and Administration and Sassan Zaker of Julius Baer explore the recent performance of a large number of hedge fund replicas. As you can see from the chart below created with data from Table 1 of their paper, the risk and reward of these funds is all over the map. The red mark below is the performance of the HFRX (note: we added the HFRX not the HFRI since it’s investable just like many of the replicas).
The period of time represented in this graph includes the bulk of the financial crisis, a period when many replicas actually outperformed hedge fund indexes. The chart below created with data from the same table shows the time period from August 2009 (after the crisis) to October 2010.
Two things immediately jump out when you look at these charts. Firstly, replicas did pretty well during the crisis, but only so-so after it. And second, the dots are all over the place. In fact, no dot comes within a country mile of actually “replicating” the HFRX – it’s no different for the HFRI. So much for “replication!”
Tuchschmid, Wallerstein and Zaker navigate around this issue by comparing the returns of hedge fund replicas not with recognized hedge fund indexes, but with a Fung & Hsieh factor models representing those indexes. This, they write, is “arguably the purpose of a hedge fund replication product.”
On that basis, hedge fund replicas seem to perform quite adequately. Most have an r-squared to an 8-factor model of over 0.80, so at least they’re in the ballpark.
Still, most of the replicas produce alpha, be it negative or positive. The chart below arranges the annual alphas of these replicas from smallest to largest; the red bar is the alpha of the HFRI Composite. In other words, if you held an equal-weighted portfolio of these products, you’d have basically zero alpha. Sad, but theoretically sound when you think about it…
The trio seems to agree with Edhec (see recent post) that the most appropriate benchmark for a hedge fund replica as a fund of funds index. Since some of the replicas are only indexes (i.e. not actual funds) their returns need to be viewed as gross of fees. So if you adjusted the after-fee returns of the whole group of replicas accordingly, you might end up with something that looks a lot like the HFRI Fund of Funds Index (check out the green and blue lines in chart below from the paper).
The bottom line, we believe, is that you can be excused for viewing hedge fund replication products merely as quant hedge funds. As Tuchschmid, Wallerstein and Zaker observe, “Investors of hedge fund replication products should not be fooled in that they are buying into an index product with the same precision as in the equity index world.”