The index revolution in hedge funds is here!
Well, actually, it arrived fifteen years ago — but established allocators spent the first decade or so fighting it tooth and nail to prevent it from spreading and, in the process, tried their damnedest to convince everyone it couldn’t, wouldn’t or shouldn’t work.
So here we are in 2022: a new generation of wealth managers is embracing factor-based hedge fund replication, an “index-like” strategy that has worked unexpectedly – even remarkably — well. For these forward-looking allocators, it’s a profound improvement over higher cost and riskier options, broadens the toolkit, and has the potential to materially improve client outcomes.
Here’s a quick guide.
Let’s Define “Index”
Everyone knows about hedge fund indices: HFR, EurekaHedge, PivotalPath, Bloomberg, etc. Each can tell you how hedge funds – illiquid, expensive, subject to high minimums – performed last month. Useful as benchmarks, they are unfortunately useless for investment purposes. Imagine trying to invest in your local housing index.
Enter factor-based hedge fund replication. In layman’s terms, it means figuring out how a lot of managers (“hedge funds”) are invested across stocks, bonds, currencies, and commodities (“factors”) and copying them cheaply and efficiently (“replication”). The beauty is that it can work in a UCITS fund with low minimums, daily liquidity, reasonable fees.[1]
Why Now?
Simply put, a new generation of allocators is taking over the wealth management space. They grew up in a world where “index” is an efficient and predictable way to get asset class exposure. They’ve watched plenty of hedge fund myths – e.g., the infallible genius — wither in the face of reality. They recognize that “active” and “passive” can and should co-exist: Millenium, the Sharpe ratio machine, may be a brilliant choice for a few elite clients, but an accessible, liquid, index-like product is far better suited to the other 99%. Through the lens of model portfolios and long-term client management, they understand the value of predictable, “index-like” results – where the benchmark can be an allocator’s best friend or worst enemy.
Where Should Allocators Start?
In UCITS land, there are three “pure play” factor replication products: SEI Liquid Alternative Fund (note: we subadvise this one), NN Alternative Beta and Credit Suisse Liquid Alternative Beta. Each has its own design nuances, yet all three have roughly matched the performance of “hedge funds” – here, for comparison, the HFRI Fund Weighted Index – with impressively high correlation:
| Data as of March 31, 2022[3] | SEI Liquid Alternative |
NN Alternative Beta |
CS Liquid Alternative Beta |
| Inception Date | November 2015 | June 2008 | January 2013 |
| CAGR (ITD, Gross) | 6.1% | 3.9% | 5.6% |
| Comparable CAGR of HFRIFWI | 6.1% | 4.2% | 5.5% |
| Correlation to HFRIFWI | 0.8[4] | 0.9 | 0.9 |
But that only tells half the story. The real comparison should be to hedge fund strategies packaged in UCITS funds. These “diluted” hedge funds – see the HFRX Global Investable Hedge Fund index – tend to underperform the real thing by several percentage points a year. By replicating the real thing cheaply, the replication funds above often rank among the top multi-strategy UCITS funds.[5] For wealth managers, this means replication-based UCITS funds are more “index-plus” than “index-like” and potentially can deliver on the allocator’s trifecta of strategy exposure, consistent outperformance and low fees.
Conclusion
One common knock on factor models is that they “replicate only beta” – not the pure alpha gold that allocators seek. This critique pre-dates the appreciation of factor rotations. Outside of some ivory tower statistics class, no one questions the “alpha” generated by, for example, the dotcom-era value vs growth trade or the recent Treasury short. And this, of course, is how hedge fund managers often describe each other: “Druckenmiller nailed the Treasury short,” “Andurrand went all in on his long crude oil bet,” “Maverick caught the value rotation early,” etc. All these factor rotations can be picked up by replication models. There are, of course, plenty of areas where you need to own the real thing – don’t try to replicate Citadel Wellington, PE-like distressed managers, or even merger arbitrage. But where replication works – hedge funds overall, equity long/short and (in our case) managed futures – it can work beautifully.
Whether revolutionary or evolutionary, it’s time has come.
[1] If interested in the trials and tribulations of trying to create index-like hedge fund products, read our Wrestling with the Hedge Fund Paradox.
[2] Jasmina Hasandhovic and Andrew Lo, “Can Hedge Funds Be Replicated: The Linear Case.”
[3] Source: Bloomberg and DBi
[4] The SEI fund has a higher allocation to managed futures than the HFRIFWI, which reduces correlation slightly.