CHICAGO — The latest challenge to the $1.3 trillion hedge fund industry could be strategies that produce hedge-fund-like performance without the hassles of investing in hedge funds.
A handful of firms have begun constructing so-called replication indexes that use multiple baskets of liquid securities to generate returns that mimic those of major hedge fund indexes.
Proponents of the methodology say that new technology, combined with a wider range of investment baskets such as exchange traded funds, have made it possible to track or replicate the returns of a hedge fund index.
The basic strategy, which has been thoroughly back-tested but has a limited performance history, could open the door to a whole new market of investors by sidestepping the high fees, illiquidity and tax inefficiency that typically plague alternative-class investments.
As they invest primarily in a blend of ETFs and futures contracts, replication index products can limit fees to the 1% range and offer daily liquidity.
That compares with funds of hedge funds, whose fees start at 1% of assets and 10% of the performance.
At least one firm, Stonebrook Structured Products LLC in New York, has begun the regulatory process to launch an ETF that replicates hedge fund index performance.
“We think the best use for this product is to deliver hedge-fund-like returns for retail investors,” said Jerome Abernathy, the firm’s managing partner. “The promised land for this is an ETF.”
Mr. Abernathy doesn’t anticipate having his ETF on the market until 2009, but last month, he started offering the unregistered Stonebrook Alternative Beta Fund, which applies the same strategy for a $250,000 minimum investment.
Stonebrook has structured and managed more than $1 billion in asset management products for institutional clients, according to Mr. Abernathy.
The Goldman Sachs Group Inc., Merrill Lynch & Co. Inc. and JPMorgan Chase & Co., all of New York, are among the major firms that have built indexes of non-hedge-fund products that are designed to mimic hedge fund index returns.
“My understanding is that it’s quite doable, and these indexes are doing a very good job of generating hedge fund index performance,” said Robert Levitt, president of Levitt Capital Management LLC in Boca Raton, Fla.
The quiet emergence of replication indexes is generating some awkward scenarios within the bustling hedge fund industry, particularly when it comes to justifying the fees associated with funds of hedge funds.
Last week in Chicago, as part of a conference of the Washington-based Managed Funds Association, two representatives from fund-of-hedge-fund firms shared a panel with Mr. Abernathy.
Although he tried to downplay his enthusiasm by suggesting that replication indexes will never grow to beyond 5% of the overall hedge fund market, his fellow panelists tried to dismiss politely the validity of such indexes.
“I think the jury is still out on these replication strategies,” said A. Nicholas DeMonico, a managing director at Commonfund Capital Inc., a Wilton, Conn.-based firm that manages $40 billion worth of funds of hedge funds.
“It seems to be going to a lot of work to replicate an average,” he added. “I don’t think anybody in the fund-of-funds space is looking for the average return; we’re looking to beat the index.”
While it might be true that investors turn to hedge funds in pursuit of alpha performance, the market average — or beta — produced by an index does exist, and this is where some observers see the greatest opportunity.
“If these things live up to their promises, investors are far better off,” said Keith Styrcula, president of Structured Funds Advisors LLC of Westport, Conn.
‘Long-term threat’
According to its back-testing models, the Stonebrook Alternative Beta Fund would have produced a 10.2% compound annual return over the five-year period through March 2007. That compares with a 9.9% return over the same period by the Hedge Fund Research Index. The Hedge Fund Research Fund of Funds index, meanwhile, averaged 7.87%, and the Standard & Poor’s 500 stock index averaged 6.27%.
Even so, a strategy based on back-tested performance will find a slow adoption rate among institutional investors, according to John Van, chief operating officer with Partner
Capital Group LLC of Nashville, Tenn.
“People are frantically trying to replicate the performance of hedge fund indexes using all kinds of things, and if you have a back test that doesn’t do what you want it to, then you don’t know how to back-test,” he said. “The proof in the pudding will be to let it go forward for a few years.”
Although nobody is predicting that investors will start racing toward replication indexes, some industry watchers are envisioning the start of a new era for alternative investments. “This is where stock indexes were in the 1970s, and I see it as a long-term threat to funds of hedge funds,” said John Rekenthaler, vice president of research at Morningstar Inc. in Chicago.
One area of real potential, according to him, is the retail marketplace, where investors could theoretically enjoy hedge fund index performance without violating regulations prohibiting them from owning certain alternative products.
“As far as I know, there’s nothing in the regulations that says we have to protect retail investors from owning a combination of ETFs,” Mr. Rekenthaler added.
