Call for Reactions

The pros and cons of passive hedge fund replication

DAVID SCHRÖDER, EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE

Following an EDHEC Risk and Asset Management Research Centre study last year on passive hedge fund replication (‘The Myths and Limits of Passive Hedge Fund Replication’, N Amenc, W Géhin, L Martellini and J Meyfredi (2007), EDHEC position paper, Nice), EDHEC recently conducted a survey with the support of Newedge to compare the results of the analysis of hedge fund replication by EDHEC’s researchers with industry perceptions of the products and techniques that are currently available.

This ‘call for reactions’, the aim of which was to have an idea of what practitioners really think about the strengths and weaknesses of hedge fund replication products, and, most important, whether they actually use them, had five multiple choice questions, including the possibility to add further comments.

The questions were sent to asset management firms and pension funds, as well as to private bankers and related institutions that are interested in optimal asset management strategies.

Most of the 97 respondents to the call for reactions were based in Europe. The survey period was from 22 January 2008 to 21 April 2008. The breakdown of the respondents’ professions can be seen in Fig.1.

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With 53% of the survey participants, asset management companies (the target group of the EDHEC study) are the largest professional category represented in this survey. Pension funds and insurance companies account for another 13% of the sample. Private bankers and family offices together represent another 13% of the respondents. The remaining 21% are other professionals in the financial service industry, such as brokers or financial hedge fund consultants.

Respondents to the survey were first asked for their views on the most promising approaches to passive replication of hedge fund returns. In this question, multiple answers were possible. The results are shown in Fig.2.

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Non-linear or conditional factor models are considered the most suitable of the replication techniques (46%). Pay-off distribution models, such as those offered by FundCreators, come next (thought promising by 15% of respondents). Only 7% are in favour of a simple linear factor model, similar to the Merrill Lynch product.

Most striking, however, is that 40% of respondents express no view of the best approach to replicating hedge fund returns. It is unclear, though, whether these respondents lack sufficient knowledge of the various products on offer, or whether they simply do not believe in any of them. In any case, this large proportion can be interpreted as a reflection of the managers’ uncertainty as to the value of these products.

The next set of questions turned to the central issue of the study: the advantages and disadvantages of passive hedge fund replication. We were interested in the practitioners’ reasons for investing or not investing in these products.

The answers to the first of two questions are shown in Fig.3. Again, multiple answers were possible.

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For many of the respondents (78%), high liquidity is the main advantage of hedge fund replication products. Fees that are lower than those of hedge funds are also a draw (67%). Greater transparency and control of operational risk are less important reasons for investing in these products.

What then are the disadvantages that asset managers have in mind when it comes to using hedge fund replication products? That was the content of the next question, to which respondents could again choose more than one answer.

As shown in Fig.4, it turns out that the respondents see basically four obstacles to investing in those products: first, they criticise the poor performance of these products. Second, they believe that hedge fund manager behaviour is not replicable. Third, they have no faith in the concepts proposed (unproven technology). Fourth, they criticise the lack of transparency (black box process). Unfamiliarity with replication products is much less of an issue. Finally, some 17% of respondents think investing in replication products is not a good idea for other reasons. The most cited additional objections are the still high fees, the poor properties of replication products (other than performance), the preference for in-house products, or a general lack of interest in hedge funds.

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In the last set of questions the call for reactions focused on the actual use of hedge fund replication. As Fig.5 shows, hedge fund replication products are not yet very popular with asset managers. Only 15% of all respondents report that they have used passive replication products. About 30%, by contrast, report that they will never do so. The majority (55%) of respondents are considering investing in replication products sometime in the future, 4% of them in the very near future.

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Finally, how satisfied are investors with their previous experience with synthetic hedge funds products? That was the last question of EDHEC’s call for reactions on passive hedge fund replication. As can be seen in Fig.6, many of the respondents feel that it is too early to say whether the proposed products are beneficial to them or not: more than half of those who have invested have yet to make up their minds. In other words, if asset managers have invested in replication products, they have started doing so only very recently.

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The remaining 44% of the respondents are split down the middle between satisfied and dissatisfied customers of synthetic products, a split that once again highlights the mixed overall views of hedge fund replication products.

This article is based on an EDHEC Risk and Asset Management Research Centre programme on hedge funds which is supported by Newedge

ABOUT THE AUTHOR

David Schröder is a Senior Research Engineer at the EDHEC Risk and Asset Management Research Centre. David obtained his PhD in Economics from the University of Bonn. During his doctoral studies, he was also affiliated with the Centre de Recherche en Economie et Statistique (CREST) in Paris. His research focuses on empirical asset pricing, the predictive power of equity analysts’ forecasts and decision making under ambiguity. He is a member of the Econometric Society and has presented at many international economic and finance conferences.