Alternative Routes to Hedge Fund Return Replication

Abstract

The author starts with the observation that although institutions are still pouring more and more money into hedge funds, hedge fund performance is clearly deteriorating. In part, this reflects lower interest rates and a global decline in risk premiums. Part of hedge funds' disappointing performance, however, is also due to the huge inflow of institutional money itself. The author then notes that driven by a desire to reduce costs and improve investor returns, the market has recently seen several attempts to “replicate” hedge fund index returns. Stating that the driving force behind hedge fund replication is the realization that the majority of hedge fund managers do not have enough skill to make up for the fees they charge, the author argues that it may be worthwhile to replace the managers in question with a synthetic hedge fund. Synthetic hedge funds produce no pre-fee alpha, but they don't cost a fortune to run and may therefore very well produce significant after-fee alpha. In addition, synthetic hedge funds come with great improvements in liquidity, transparency, capacity, etc. The article proceeds to discuss three different approaches to replications.