Ah, the good old days – when the hedge fund “secret sauce” was revealed and suppliers set about developing the products that would bring it to investors the world over under the moniker “hedge fund cloning”.  But as Swiss researchers Erik Wallerstein, Nils Tuchschmid and Sassan Zakerc note in a recent paper called “How do hedge fund clones manage the real world?”:

“Some years ago hedge fund replication was a much discussed topic on the hedge fund horizon. A credit crunch and some hedge fund Ponzi schemes later, the attention has turned elsewhere.  2008 performance of broad hedge fund indices where dismal at best. This did not bode well for selling pitches to persuade investors to turn to funds which replicate this performance.”

However, the trio goes on to argue that the $2 billion hedge fund replication business is far from dead.  Hedge fund replicas, they say, “…have several unique and interesting features, many which where attractive during the crises of 2008.”

They analyze the recent performance of 21 hedge fund clones from 17 companies covering the full spectrum of replication techniques from factor replication to distributional replication to mechanical replication.  (see the “Alternative Beta and Hedge Fund Replication” category at the right side of this page for extensive coverage of these topics).

Here’s how the 21 fund stack up from March 2008 to May 2009 (chart based on data in paper)…

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We’re in Chicago this week for the Managed Funds Association’s Forum 2009.  More on that later.  But for now, here is a compilation of some stories that caught our eye last week…

Gates designed to keep investors out, not in

It was bound to happen.  Reuters reports that:

“A small number of top hedge funds are once more shutting their doors to new clients in a sign that investors are putting their cash back with the best performing managers, said fund of funds Corazon Capital.

“While heavy outflows last year meant almost all hedge funds were open to new investors, Barrie Duerden, director of Corazon Capital, told the GAIM 2009 conference here that in recent weeks some managers were now turning away business again.”

Gated Communities

As in real estate, however, such “gated” communities are for a ratified crowd.  While “top hedge fund” are closing their doors, Reuters also reports that most hedge funds have ramped up the marketing machine, quoting one participant at a recent conference as saying:

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It is often argued that aggregate hedge fund performance data suffers from a near-fatal flaw: since it is voluntarily reported by the manager, hedge fund indices only include funds that the managers have deemed marketable.  In 2002, David Hsieh of Duke University and William Fung of London Business School wrote a seminal article on this issue called “Benchmarks of Hedge Fund Performance: Information Content and Measurement Biases.”

In contrast, regulations often require mutual funds to register with securities authorities before they can begin to assemble a track record.  As a result, mutual fund data is assumed to be free of such bias.

But as Alan Palmiter and Ahmed Taha, law professors at Wake Forest University write in a forthcoming article for the Vanderbilt Law Review called “Star Creation: The Manipulation of Mutual Fund Performance Through Incubation“, the requirement for a mutual fund to register does not eliminate the problems arising from so-called “mutual fund incubation.”

Observe the professors:

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Those new to the hedge fund industry often find the concept of “buying volatility” and “selling volatility” to be somewhat confusing.  Volatility, after all, is not a tangible thing that can be bought and sold (save for the VIX), but is rather a description of tangible assets (a “volatile stock” or a “low-volatility fund”).

Yet hedge funds are often accused of simply “selling” volatility to generate returns, resulting in them being “short volatility”.  A short position in a stock implies that you would gain if the stock went down and lose if the stock went up.  Similarly, a short position in volatility implies you would gain if volatility went down and lose if it went up.

So how could you construct a position that would gain when volatility goes down and lose when volatility goes up?  Sell (i.e. write) options contracts.

Not unlike writing an insurance contract, writing options generates a steady stream of premiums with no apparent cost – until the judgment day comes.  In other words, if volatility unexpectedly jumps (as it does in severe market downturns), then you’d have to pay the piper.  Obviously, this could erase all of the apparently risk-free returns you seemed to be receiving by writing options over the the years.

Some say that’s how hedge fund managers really make their money.  Last year, we told you about a paper by Wharton’s Dean Foster and Peyton Young of Oxford University that claimed, among other things, that hedge fund managers routinely “fake” their alpha by simply writing puts and collecting the premiums (see post).  Wrote Foster and Young:

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By design, hedge funds have a much lower correlation to equity market indices than mutual funds.  Regular readers may remember this chart from a presentation given by Bill Fung and David Hsieh to the Atlanta Fed back in 2006.  The chart shows the proportion of both hedge funds and mutual funds that fall into each of ten buckets based on their correlation to equity markets. 

Now a new paper by researchers at the University of California takes the same general idea and applies it to hedge fund strategies themselves.  The authors Lu Zheng and Ashley Wang aim to determine if manager and strategy “distinctiveness” is a predictor of positive alpha in the long run.  To do this, they use a measure they call the strategy distinctiveness index.  The “SDI” is simply one minus the r-squared of the manager’s return vs. those of her peer group. 

Once the SDIs for over 2000 hedge funds in the Lipper Tass database were calculated, Zheng and Wang grouped them into deciles.  As you might have guessed, certain hedge fund strategies tended to be the home of highly idiosyncratic managers with a low average correlation to their sub-index (e.g. market neutral), and certain strategies tended to be the home of a large number of managers with a high correlation to their sub-index (e.g. CTAs). 

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Bill Fung

Visiting Research Professor at the Centre for Hedge Fund Research and Education, London Business School. Serves on the board of  financial services companies in Europe and North America and is currently Chairman of the Board of Directors of the Maple Financial Group, Canada.

Homepage/Contact Information (LBS)
Research (SSRN)
BNP Paribas Hedge Fund Centre
Relevant Postings (AllAboutAlpha.com)

“We essentially have 10,000 Ph.D.s looking at the same data.”

That’s how Vadim Zlotnikov, CIO for growth equities at AllianceBernstein described the world of quant funds to the Annual Meeting of the CFA Institute last week in Vancouver.  Zlotnikov was talking about the findings of a new paper by the Research Foundation of the CFA Institute based on a survey of asset managers, consultants and investors.   

A press release announcing the study confirms what is now commonly believed, that August’s mayhem was mainly the result of quant hedge funds yelling “Fire!” and running for the exits (see related posting).

Larry Siegel, the Director of the Research Foundation of the CFA Institute (see previous guest posting), points out the supreme irony of this development:

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In the late 1990’s a couple of academics David Hsieh (Duke University) and Bill Fung (London Business School) wondered if traditional statistical analysis was appropriate for a new type of investment fund – the hedge fund. Although they had collaborated since early that decade, their 1997 paper “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds” put the two on a collision course with history.  Several years later they teamed up with the equally prolific Narayan Naik, who worked with Fung at LBS and met Hsieh at Duke while doing his PhD.  Last week the trio landed another in a long string of commercial successes advising some of the world’s most powerful financial institutions.

On Friday, State Street Global Advisors announced they had landed a US$200 million “hedge fund replication” mandate from the Universities Superannuation Scheme, a British pension plan serving the country’s academic community.  This is newsworthy since its one of the first major pensions to pursue such a strategy (although there has been lots of talk).

A State Street official sounded a refrain that will be familiar to regular readers of AllAboutAlpha.com:

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Here is a sample of the news stories we didn’t get a chance to explore in detail this week.  As usual, all of them can be found on the Alpha-ticker above or in the news items section of AllAboutAlpha.com (free registration may be required for a few of these).

Morgan Stanley says Alpha/Beta Separation “the way of the future”. The AllAboutAlpha site partner lays out its alpha-centric philosophy telling IPE that the pension industry is about to experience a “second wave” of LDI strategies based on the separation of alpha and beta.

Dutch Insurer Aegon splits portfolio into alpha and beta segments are farms each one out to a different manager. According to the firm’s press release, “By managing the parts separately from one another, better risk-return ratios are possible. This way, more sources of value added will be available and a greater focus can be created in the portfolio. Separating the US share portfolio has created an increase of a yearly average of the total return of 2.5% without any risk increase.”

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Earlier today, a conference wrapped up in London featuring some of the big names in the hedge fund replication industry (Bill Fung & David Hsieh – see related news item from today, Lars Jaeger – see related posting, and William Shadwick – see related posting, and others).  In case you couldn’t make it to this powwow, you’re in luck.  We trained an uncommonly intelligent house fly (he prefers the name “Musca Domestica”) to take notes over the past two days and send them to us by a miniature fly-sized Blackberry.  What follows are the Blackberry ruminations of our ‘fly on the wall’ at the world’s leading alternative beta gabfest.

9:00 AM Monday, March 10: “Got in yesterday despite the bad weather back home and a 300 mph jet stream (which also cramped up my wings a little – had to get a wing massage – but don’t worry, I won’t expense that).  Nice Sunday afternoon in London though.  Saw a Goose and a Black Swan cavorting yesterday in the park across from Buckingham Palace.  Bad omen?  Daffodils are blooming here, but storm coming in to London today.  Miserable this morning.  Hopefully send something more interesting about replication shortly.”

10:23 AM: “Peter Norman from AP7 discussed their separation of alpha and beta (see related posting). They get beta for free given its low-cost. Then they pursue alpha through risk budgeting to managers and not through capital allocations.  Long positions are funded by short positions.  AP7 covers any temporary losses and allows managers to use their credit.  Risk allocation is done using a tracking error methodology carried over from their old long-only active management approach.  Going forward, contemplating moving to a VaR approach.”

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This week’s Economist contains a great analysis of how commonly-held beliefs about hedge funds may be urban folklore.  In fact, the piece makes so many succinct arguments, that we can’t really add much other than to suggest a few related AllAboutAlpha.com postings for anyone looking for additional perspective.

“Trying to assess the behaviour of hedge funds is a bit like attempting to nail a blancmange to the wall.  It is all too easy for the truth to slip away.”

“…Take hedge-fund failures. Most funds close down because it does not pay their managers to continue, not because their performance has been disastrous.  For every Bear Stearns ‘enhanced-leverage’ fund that loses all of its value, there are five or six funds that shut after a fall of a few percentage points…Doubtless more hedge funds will fail this year, but that will not necessarily be a sign of the industry’s demise.”

(Related posting: “Are some hedge funds sinking or just sailing into the sunset?”)

“…A survey by William Fung and Narayan Naik of the London Business School examined five different benchmarks and found that only 3% of constituents were common to all of them.”

(Related posting: “Only 3% of Hedge Funds in All Five Major Databases“)

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