Hedge fund proxies

30Aug06

Back on the topic of hedge funds, CXO Advisory Group highlights yet another interesting paper that raises a most fascinating question: Can hedge fund returns be cloned? Surprisingly the short (but qualified) answer is yes. While it is clearly easier to replicate the returns of a larger universe of hedge funds, than any individual hedge fund, there seems to be some merit in this “synthetic hedge fund” approach.

This is not the first study to replicate hedge fund index returns with common indices or factors. These studies show that is is possible to tease the exposures or betas, from hedge fund indices. It highlights two important points.

First, as one abstracts away from individual funds a clearer picture emerges in regards to hedge fund sector exposures. The idiosyncratic ways of any individual fund would be difficult to replicate without knowledge of the underlying portfolio, but in general certain hedge fund sectors have common factors. This helps highlight the division between beta and alpha for hedge funds in general.

Second, the benefits from a synthetic approach are not in the returns, but arise from all of the intangible benefits. Hedge fund investing by any measure is expensive. From the (now) typical expense schedule of “2 & 20” to the monitoring and due diligence costs it takes a great deal of effort to tease alpha from the capital markets. In contrast a synthetic approach is based on publicly traded, liquid vehicles. The authors of the paper note that synthetic hedge funds are beta-replication strategies as opposed to the now all-popular portable alpha strategies.

We found the paper particularly interesting because it echoes some longstanding themes of this site. For example a synthetic hedge fund approach could be categorized as a subset of what we call proxy investing. That is identifying and investing in vehicles that have the ability to proxy for broader investment themes. Second, the growing number of hybrid funds, that use hedge-fund like strategies within the confines of open-end mutual funds, show that there is both demand for, and an ability to bring these strategies to individual investors.

The whole point of this piece is not to give the reader the impression that synthetic hedge funds or proxy investing is easy, or even advisable – it is that it is possible. The increasing number and diversity of investment vehicles is making possible strategies for individual investors that were once available only to institutional investors just a few short years ago. However, with that increased power comes responsibility. Just because you can do something, doesn’t mean you should.

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