Readers of the FT over the weekend learned that “a new breed of hedged mutuals grows apace.”  The paper reports that investor demands for liquidity and transparency in hedge funds have forced managers to “try something different.”

But as regular AAA readers are aware, the convergence of hedge funds and mutual funds have been occurring for several years (see end of this post).  In fact, we covered a seminal paper on this subject 3 years ago.  In “Hedge funds for retail investors? An examination of hedged mutual funds” Vikas Agarwal, Nicole Boyson, and Narayan Naik wrote:

“Recently a number of mutual fund companies have begun offering mutual funds that emulate hedge fund strategies, with assets tripling since 2002…over half of the Registered Investment Advisers who do not currently use hedge funds for their clients would add hedged mutual funds to their portfolios.”

The trio concluded that hedge fund managers seemed to be more adept at, well, managing hedge funds:

“…using hedge fund strategies, even within the constraints of the mutual fund environment, can significantly improve performance.”

While “hedged mutual funds” may not be that new, the Madoff Affair may have certainly made them more interesting to retail investors.

A new report by BNY Mellon’s Pershing Prime Services unit and consultancy Finadium (“Competition and Convergence: The Evolving Landscape for Hedge Funds” – available here with free registration) finds that traditional asset managers are adding long/short funds to their line-ups at an astonishing rate.

The companies forecast that the amount of long/short assets managed by traditional money managers will increase by a whopping 75% to $345 billion by 2012.  Meanwhile the amount managed by actual long/short equity hedge fund managers will increase by only 25% to $580 billion.  (Those of you who contend that long-only managers have no business shorting may find this to be further evidence that 2012 will indeed herald the end of the world.)

Back in 2004, Agarwal, Boyson and Nail found that their 39 “hedged mutual funds” (Table 7 of their report) represented about 2% of all hedge funds.  BNY and Finadium find that today, there are 157 such funds managing $27 billion or about 4% of all hedge fund assets (see chart from report below):

But while $27 billion may represent a significant portion of the hedge fund industry, it’s a 0.1% drop in the bucket for the greater mutual fund industry.  In part this seems to have fueled BNY Mellon’s and Finadium’s apparent optimism about the future of long/short mutual funds.  Says the report:

“Soon, long/short mutual funds may very well be a recommended piece of every retail client’s portfolio. Presuming that financial advisors eventually recommend that even 2% of their clients’ assets should be in market-neutral strategies, the equity long/short space could easily grow twenty-fold over the next five years. Given the need for investors to recoup losses sustained in the last year, this recommendation could well make sense.”

Other Similarities

As hedge funds and mutual funds begin to eat each other’s lunch, their leverage levels are also converging.  According to the report (and backed up by several studies we’ve covered here), hedge fund leverage is now almost non-existent – i.e. the same as mutual fund leverage.

Mirroring the industry concentration of the hedge fund sector itself, the top 10 hedged mutual funds manage around two-thirds of all hedged mutual fund assets.  By contrast, the bottom 122 (of 157) funds manages only 10% of all hedged mutual fund assets.

Hedge fund regulation has the potential to increase the speed of convergence.  According to the report, traditional managers felt that “few, if any differences” would remain between hedge funds and traditional managers if hedge funds were to be regulated as investment managers.

Oddly, however, nearly half of traditional managers thought hedge funds were eating their lunch by “institutionalizing” their offerings but hedge fund managers didn’t feel all that threatened by traditional investment managers – citing the usual reasoning that they lack the necessary short selling skills.

So What?

Although long/short funds managed by traditional managers are forecast to grow faster than those actually managed by hedge funds, there remains a significant opportunity for hedgies.  According to the report, hedge funds could partner with traditional managers to launch new products on a sub-advisory basis, and, in effect, leverage the traditional managers’ distribution channels

Considerable risks remain for hedge funds, however.  Chief among them, according to the report is the fact that retail offerings may lead institutional and high net worth investors to believe that hedge funds “…are no longer exclusive enough…”

This is a topic of critical importance to both hedge funds and mutual funds.   As this report and others like it illustrate, it’s not about hedge funds or mutual funds, it’s all about alpha.

Related stories on “convergence” at AllAboutAlpha.com:

2009

• Hedge fund / mutual fund convergence in Europe and the US seen to “mirror” each other
• Financial crisis to slow convergence of hedge funds and private equity, but not for long, says academic
• More evidence of asset management “convergence”

2008

• Hedge Funds and Mutual Funds: Not such an odd couple – as long as conflicts of interest are managed
• “Convergence” gets another shot in the arm from recent calamities
• January turmoil has “sharpened the argument for the convergence of traditional and alternative asset management”: Report
• 130/30 “not monolithic” but does represent a “convergence” in money management

2007

• Convergence at The Rockefeller Center
• “The more we get together, together, the happier we’ll be…”
• Hedge funds for retail investors? An examination of hedged mutual funds
• 2007: Year of Hedge/Mutual Fund Convergence?

2006

• BGI CEO tells FT about “artificial distinction” between hedge and long-only

Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers the topic of Alternative Beta and and Hedge Fund Replication…

With hedge funds back in the black, how are the hedge fund “clones” doing?
At least one hedge fund “replicator” has recently been replicating the aspirations, if not the actual experiences of hedge fund managers.

A novel approach to monitoring daily HF returns when they don’t actually exist
Hedge fund replication is now put to a different use by researchers.  Call it “assisted hedge fund replication”.

Pendulum swinging back to investable hedge fund indices for passive HF exposure
It wasn’t long ago that investors were graduating from simple investable hedge fund indices to more sophisticated hedge fund replication products for their passive hedge fund exposure.  Now, it seems that “simple” is back as some investors are willing to stomach the high hedge fund fees in exchange for transparency and liquidity.

More…

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:

More…

Thought recent develops in the hedge fund industry such as poor performance, SEC registration, and taxation were unprecedented?  Yeah, so did we – until Nicholas Motson of the Cass Business School (see related post), gave us a heads-up about a fascinating FORTUNE magazine article by Carol Loomis (who went on to enjoy an illustrious career in business journalism and remains a Senior Editor-at-Large with the magazine) from the January 1970 issue.  The entire article can be downloaded here on the A.W. Jones & Co. website (yes, that A.W. Jones – the father of the hedge fund industry).

As you will see, the similarities between the hedge fund world of 1970 and that of 2008 and truly amazing – almost eerie in fact.  Even the 39 year old Warren Buffett makes a cameo in this piece.  As Motson pointed out to us, “…if you re-scale the numbers it could have been printed yesterday.”

The bizarre parallels begin with the article’s very title: “Hard Times Come to Hedge Funds“.  It goes on to chronicle the travails of the $1 billion industry (as a point of reference, the US mutual fund sector managed about $50 billion at the time).  FORTUNE estimated there were 3,000 investors in about 150 hedge funds by 1970.  Most funds were launched between 1966 and 1970 and “the great bulk” were registered in Manhattan (that’s just south of Greenwich, for those who may not remember the old days).

Trouble in Paradise

FORTUNE described these 3,000 investors as mostly “wealthy…important businessmen.”  Their returns had been good for a few years.  But, wrote the magazine…

“…some today are troubled about their hedge fund investments.  Their misgivings are something new, for until recently, the hedge funds looked like an investor’s dream.  The records they produced were consistently lustrous, and it seemed as if their structure was ideally geared to success.”

“In general, hedge funds were clobbered by the 1969 bear market…The 1969 experience has been a rude awakening for many hedge fund investors and has left some of them with strong reservations about the whole concept.  For the first time in their relatively short history, the funds are not growing; in fact, some have suffered large withdrawals for capital and a few have actually folded.”

“What remains, however, is still a big business, for in the last few years, the hedge funds have both proliferated in number and exploded in size.”

“Hedged Mutual Funds”

In a 2006 paper called “Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds” (see related post) academics Vikas Agarwal, Nicole Boyson, and Narayan Naik wrote that:

“Fairly recently, a number of mutual fund companies have begun offering funds that use hedge fund-like trading strategies designed to benefit from potential mis-pricing on the long as well as the short side.”

But as the January 1970 FORTUNE article points out, the concept actually has a long history.  Wrote FORTUNE:

“…the last couple of years have seen the formation of some  twenty-odd mutual funds that are patterned after the private [hedge] funds and that are commonly also identified as ‘hedge funds’.”

Tiger Children

When disciples of hedge fund legend Julian Robertson left Robertson’s Tiger Management to launch their own funds, the hedge fund community branded them as “Tiger cubs”.  But Robertson wasn’t the first to produce such prodigy.  Reports FORTUNE:

“Because he was running private partnerships, [Alfred] Jones was able to keep the dimensions of his success very quiet, and he had no imitators of any consequence until 1964, when one of his general partners – the first of several to do so – peeled off to start his own fund…These funds are sometimes jokingly referred to as ‘Jones’ children’…”

And as incontrovertible evidence that there are only so many hedge fund names in the world to choose from, two of these “children” were called “Fairfield Partners” and “Cerberus Associates”…

More…

One of the questions that is often posed to hedge fund managers revolves around the fair allocation of investment ideas to individual funds. If a manager has several funds with varying hurdle rates, performance fees, and management fees, then the manager may have an incentive to funnel her best trade ideas into the one with the most lucrative compensation framework. Add to this the fact that some of those funds might be under their high water mark and some may be home to a disproportionately large personal investment by the manager and investors can get very nervous. The result is often a requirement for a fixed, written policy on trade allocation between funds.

The same kind of conflicts can also exist when a hedge fund manager also manages a mutual fund. Last week we discussed the accelerating phenomenon of “convergence” between hedge funds and traditional long-only funds. We cited an FT article on the possible conflicts resulting from such a practice:

More…

BNP Paribas Hedge Fund Centre, London Business School

Director: Narayan Naik, nnaik [at] london [dot] edu

From the Institute’s Website: Key Aims: To undertake research into all aspects of hedge fund investing, including the impact of hedge funds on the asset markets they invest in; To encourage others to conduct research, for example through visiting research fellowships and through invitations to present research at London Business School; To encourage better understanding of hedge funds.  More…

Working Papers, Published Papers

Related AllAboutAlpha Content

Narayan Naik

Director of BNP Paribas Hedge Fund Centre, London Business School

Faculty Profile (LBS)
Research (SSRN)
Relevant Postings (AllAboutAlpha.com)

More from London (see yesterday’s posting for background)…

A pension plan as a financial services firm

As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds.  The only difference between this fund of funds and a real fund of funds is that the pension has only one client: its own pension plan.

It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole.  That’s how one major private pension fund described it to a gathering here in London today – as a financial firm that produces pensions.

This view also has implications for liability-driven investing (LDI).  Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm.  For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a matching portfolio designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets.  In true arm’s length fashion, the return portfolio is required to literally borrow assets from the matching portfolio – creating a real economic incentive to beat the short-term rates charged on this internal loan.

More…

Subscribers to our monthly email update “Alpha Mail” will notice that one of the top 10 most popular postings last month was one on a research paper by William Goetzmann of Yale University that explores ways that investment managers can potentially “game” their compensation system to generate illusionary alpha.

Now Wharton’s Dean Foster and Peyton Young of Oxford University and the Brookings Institution have added to the manager-as-scammer literature with a new paper entitled “The Hedge Fund Game: Incentives, Excess Returns and Piggybacking“.  In it, they decry the proliferation of “fake alpha” (e.g. selling options and using the wrong benchmark to calculate alpha).  The paper was published in January, but didn’t start making serious waves until mid-March when Martin Wolf, Chief Economics Commentator at the Financial Times wrote a column about it.

Wolf points out the asymmetry inherent in any type of incentive fee and holds up the Foster/Peyton paper as a “beautiful” example of how incentive fees can be gamed.  He says that such a structure bears a resemblance to the used car industry.  Like the used car industry, he says the hedge fund industry “is bound to attract the unscrupulous and unskilled.” [Ed: We're reminded of the famous Forbes cover story on hedge funds in May 2004 "The Sleaziest Show on Earth"]

More…

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:

More…

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.”

More…

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“)

More…

“Your clones are very impressive. You must be very proud.”

- Obi-Wan Kenobi, Star Wars Attack of the Clones, 2002

Star Wars fans may remember Obi-Wan Kenobi’s famous words after cleaning up by shorting Death Star sub-prime debt in a galaxy far far away then hedging it with a Sith-Jedi total return swap.  But was Kenobi serious, or was he just being flippant?  Was he really impressed with the clones?

French business school and research institute Edhec also takes a moment this week to pay tribute to the burgeoning ranks of clones – these ones of the hedge fund variety.  In this article, Edhec’s Walter Gehin discusses the key players in the field, but like Obi-Wan, is somewhat obtuse about his personal feelings on the subject.

The piece contains a great listing of all the current (major) hedge fund clone offerings (e.g. ART, ABI, ARB, T-Rex, Altera, MAST, ABS – seriously, these are all real names) and divides them into two main categories: factor-based and rules-based.

While he seems to agree with the general concept of factor replication, Gehin strikes a note of skepticism:

More…