The hedge fund industry has recently reported positive news about its recovery. The aggregate performance of hedge funds recently surpassed its pre-crisis peak and total asset under management is back up to 2007 levels. The current low interest rate environment is likely to continue to underpin this demand. Investors are nevertheless still wary because of their experiences with gating and lock-ups of their traditional hedge fund holdings. These concerns may be alleviated through hedge fund replicators that provide genuine daily liquidity and transparency.
The mid-2000s saw the creation of various hedge fund replicators whose aim was to track the aggregate performance of the hedge fund industry using liquid instruments. These hedge fund replicators are now worth revisiting, as they have the benefit of a track record lasting several years including a global financial crisis.
Historically, hedge fund replicators have been accessible only through OTC or note format, which ruled out access to all but the most sophisticated investors. UCITS funds that provide exposure to hedge fund replicators can provide access to a much broader spectrum of investors. For this reason, in October 2010 Barclays Capital launched a UCITS fund that provides exposure to its flagship hedge fund replicator.
Why replicate hedge funds?
Hedge fund replication seeks to provide investors returns that are broadly similar to those of a diversified pool of hedge funds with several attractive features.
Hedge fund replicators typically employ instruments such as futures and forwards that represent broad asset classes, markets and geographies and therefore offer deep liquidity. Some of these products (including LBAR) even offer investors the ability to transact on a daily basis. The ability to quickly unwind an existing hedge fund exposure, which is typically not available when investing directly in individual hedge funds, is important to investors, especially in light of their experience during the recent financial crisis. Deteriorating market conditions have, in the past, caused large redemption requests from traditional hedge funds and consequently forced many hedge funds to restrict investors’ access to capital for prolonged periods.
Hedge fund replicators also offer investors improvedtransparency in terms of performance and risk. The fact that these products are rule-based allows for complete documentation of the portfolio construction process and ex-ante risk analysis. In addition, the nature of the underlying portfolio instruments enables daily performance calculation. Hedge fund replicators also boast several other advantages such as large capacity, reduced counterparty risk and a reduction of ‘key person’ and event risk.
Another differentiator between hedge fund replicators and traditional funds is the fee structure. While hedge funds typically charge investors a fixed fee of 2% and performance fee of 20%, replicators generally do not carry performance-based fees and their fixed costs (reflecting mostly transactions costs) are lower. The lower costs stem from the absence of active management as well as from the ability to trade the underlying portfolio factors in a cost-effective way.
Unlike traditional fund managers whose performances tend to cluster around a benchmark, the dispersion in performance among funds of funds (and individual hedge funds employing the same strategies) is potentially large. Investors in funds of funds are therefore exposed to ‘manager selection risk’ and can experience performance that is very different from that reported for the benchmark. In contrast, hedge fund replicators are designed to replicate the average performance of a broad universe of hedge funds, and therefore eliminating ‘manager selection risk’.
Applications of hedge fund replicators
Hedge fund replicators lend themselves to a wide array of applications for different investor types. Replicators may be appropriate for institutions looking to gain exposure to the performance of hedge funds as an asset class, but still maintain a similar level of liquidity and transparency to their investments in ‘traditional’ asset classes. In addition, replicators address the needs of investors who do not possess the knowledge and scale to pick individual managers and would like to mitigate manager-selection risk.
Hedge fund replicators can also complement direct investments in hedge funds. Pension funds with an explicit allocation to an ‘alternatives’ bucket can employ a ‘core-satellite’ approach, where a carefully selected set of alpha generating hedge funds is combined with a replicator as the core investment. This approach provides access to the systematic portion of hedge fund returns in a cost-efficient way. It also allows investors to focus their efforts on a limited number of funds as the satellite investment and select those that are truly alpha generators.
Another potential use of replicators is liquidity management for funds of funds. To ensure the settlement of redemption requests, funds of funds allocate some their capital into liquid assets. Rather than holding cash which may have negative impact on their performance relative to their peers, funds of funds can invest in a replicator which is liquid yet offers a return profile similar to that of hedge funds.
Although replicators aim to offer returns similar to those of hedge funds, they are technically not hedge funds. This makes them accessible for investors who may be restricted from investing in hedge funds but would still like to have exposure to this asset class, or for investors who have exhausted their limits on their allocation to hedge funds and would still like to achieve a higher economic exposure to alternative investments.
Drivers of hedge fund performance
Hedge fund performance arises from three sources: alpha, fundamental market exposures (beta) and market timing. Alpha represents the part of returns that is truly uncorrelated with systematic risk factors (for example, resulting from security selection). The beta component reflects the set of fundamental, strategy-specific market exposures. As such the strategy betas can be considered largely stable over time. In contrast, market timing represents the returns generated from active portfolio reallocation compared with holding a static portfolio containing the same factors.
The distinction among the three sources of hedge funds performance is important since they differ in terms of how well they can be replicated. Alpha cannot be replicated by definition, as it is uncorrelated with any systematic factors. In contrast, if the proper set of factors is used, the set of strategy betas can be successfully captured. The extent to which the market-timing component can be captured depends on the frequency and magnitude of repositioning by hedge funds across the various markets. The ability of any systematic, rules-based trading strategy to replicate hedge fund returns hence will depend on the relative contribution of alpha, beta and market timing to overall hedge fund returns.
Barclays hedge fund replication (LBAR)
Barclays’ alternatives replicator is based on factor-based replication. This approach relies on a set of instruments (factors) representing broad markets and asset classes (e.g., S&P500). The portfolio composition is determined such that it has the best fit with a historical time-series of returns of a reference set of hedge funds (typically a benchmark hedge fund index). The portfolio is re-balanced periodically as new return data becomes available.
The replication methodology underlying Barclays replicators was launched by Lehman Brothers in October 2007 and actively traded until September 2008. In February 2009 Barclays re-launched the replication strategy
Fig.1 plots the monthly performance of LBAR and HFR Composite Index since the launch of the replication methodology. The chart indicates that despite the extreme market conditions that characterised the period LBAR was successful in tracking hedge fund performance, even with the high market volatility and reversal in long-term trends (e.g. commodities, foreign exchange) during this tumultuous period.
Barclays Hedge Fund Replicator Fund
Barclays Hedge Fund Replicator Fund is a UCITS fund that provides exposure to LBAR and is managed by Barclays Capital Fund Solutions, the asset management business of Barclays Capital. The fund offers daily liquidity and aims to track the performance of the global hedge fund industry in a regulated, transparent and cost efficient manner.