Introduction to Synthetic Funds

High quality diversifiers for efficient portfolio management

HARRY M. KAT

Over the past 10 years, investors have had a lot to deal with. Stock markets went up and came down again in an almost unprecedented fashion. At the same time interest rates came down to historically low levels. As a result, many of today's investors have difficulty seeing profit potential in traditional assets. Stock markets are hesitant and bond prices will come down when interest rates rise again. With memories of double-digit returns still fresh, this has driven them towards alternative investments.


Hedge funds have become extremely popular. Investing in hedge funds comes with many drawbacks, however, including the need for extensive due diligence, liquidity, capacity, transparency and style drift problems, excessive management and incentive fees, and possibly regulatory problems as well.

Of course, as long as investors are rewarded with (close to) double-digit returns, and as long as stocks and bonds perform worse, they will take these problems for granted. However, this is no longer the case. More and more hedge fund investors are realizing that the golden goose has not produced any eggs for quite a while. The HFRI Fund of Funds Composite Index for example, returned 4.07% in 2000, 2.8% in 2001, 1.02% in 2002, 11.61% in 2003, 6.86% in 2004, and 7.49% in 2005.

With the end of 2006 approaching, investors are looking at another year of rather disappointing hedge fund performance. Until November, the HFRI Fund of Funds index has produced no more than 6.57%. At the same time, equity markets have performed quite well, with the major stock market indices up by 10-12% so far this year. Why does (fund of) hedge fund performance keep disappointing year after year, many investors will ask themselves? Of course, interest rates are low and risk premiums worldwide are in quite a depressed state, but the main reason of course are the massive fees that are taken out by the (fund of) fund managers before the money reaches the investor. Without those fees, funds of funds could easily produce 10%.

So what is the question that is on many hedge fund investors' minds these days? The challenge is simple: "Is there a way to get rid of those managers, while hanging on to the returns?" Basically, this is an exercise in damage control comparable to what is going on in corporate UK where the question "How do I get rid of the pension fund?" is very high on every CEO's list.

So far, in their quest for new diversifiers investors have systematically overlooked one alternative. Modern risk management techniques make it possible to obtain virtually any desired risk profile by dynamically trading traditional assets such as cash, stocks, bonds, etc. This means that investors do not necessarily have to venture into the great unknown of alternative investments to find new diversification opportunities. They can be found right on their doorstep. An additional benefit is that this form of diversification avoids all the usual drawbacks of alternatives, as trading is mechanical and done exclusively in highly liquid markets.

The basic idea of dynamic trading was put forward by Kenneth Arrow in 1953. He pointed out that, instead of following a buy-and-hold strategy, by trading more often investors can exert greater control over the evolution of the value of their investment portfolio.

This is an extremely important observation as it implies that when a given risk profile is not directly available in the market, either as an individual asset or as a combination of different assets, investors may still be able to create it themselves by trading the available primitive assets in a specific way. We have adopted this very principle and applied it to design futures trading strategies that generate returns with predefined statistical properties, i.e. returns with a prefixed volatility, skewness, correlation with stocks, correlation with bonds, etc. For simplicity, we refer to such strategies as "synthetic funds" and to the technology used to design them as the "FundCreator approach" (after the website www.FundCreator.com where this technique has been made available to investors).

Synthetic funds can be used in a variety of ways. One is the replication of existing (funds of) hedge fund returns. Given an individual hedge fund, fund of funds, hedge fund portfolio or hedge fund index, the FundCreator approach can produce a futures trading strategy that generates returns with the same statistical properties as found in the track record of the fund, portfolio or index under consideration.

Such a strategy allows investors not only to avoid the excessive fees that have turned funds of funds into glorified savings accounts, but it also allows for a highly liquid, highly transparent investment. In a recent series of studies (details of which can be found on www.cass.city.ac.uk/airc), we applied this idea to the replication of roughly 500 funds of funds and 2000 individual hedge funds.

Not surprisingly, this showed that in 82% of the cases the average return on the replicating strategy exceeded the average return on the original hedge fund. Any rational investor who appreciates how difficult it is to (ex-ante) identify the managers belonging to that 12% group of outperformers, will prefer a low-cost, liquid replica over the real thing any time.

Another, even more exciting application of synthetic funds is the creation of completely new funds, providing investors with completely new, previously unavailable return characteristics. Finding and selecting new diversifiers is a very laborious and costly process. Typically, a fund's risk-return profile is not immediately obvious and investors have to dig long and hard to gather sufficient information, if ever. This is where being able to create any type of risk-return profile pays off huge dividends, as it allows us to structure exactly what investors are looking for. No longer do investors have to work with what happens to be available and guess what a fund's true risk-return profile is. Given an investor's existing portfolio, we can structure a special tailor- made synthetic fund that produces returns, which fit in optimally with what is already there. Clearly, this is a much more natural approach than the usual beauty parades held by investors.

The creation of a new synthetic fund is very similar to what goes on in genetic engineering: take whatever is available in nature as a starting point and then improve it. A farmer for example will have very specific ideas about what makes for a good cow. If he thinks that bigger udders, more muscle tissue and no horns will make for the perfect cow, then that is what the genetic engineer will aim for. In synthetic fund design we follow the exact same procedure. Take an existing fund (of funds), ask yourself what you don't like about it and change that to something you like better. The result is a synthetic fund with almost ideal risk-return properties: zero correlation with stocks and bonds, slightly positively skewed returns, etc. Basically, the kind of diversifier that every investor dreams of, but was never able to find.

The above almost sounds like science fiction, but it is not. Extensive, highly realistic backtests (more details on which can again be found on www. cass.city.ac.uk) have confirmed that FundCreator strategies are indeed capable of accurately generating returns with a variety of highly desirable properties, including zero and even negative correlation with stocks and bonds. Under difficult conditions, these tests have also yielded impressive average returns. Combined with their liquid and transparent nature, this makes synthetic funds an attractive alternative to direct investment in alternative asset classes such as (funds of) hedge funds. Undoubtedly, investors will need time to come to grips with the concept, but given these benefits, there is no doubt synthetic funds have a bright future ahead of them.

Harry M. Kat is Professor of Risk Management and Director of the Alternative Investment Research Centre at Cass Business School, City University, London.