Hedge Fund Clones - What's the Point?
It's awfully sweet that Goldman Sachs and Merrill Lynch are introducing investment products that attempt to replicate Hedge Fund Returns without the 20%-plus fees of Hedge Funds. But one must wonder what the point is, given that most hedge funds don't beat the S&P 500.
The race is on to commercialize synthetic hedge funds. For the past few years, academics have been discussing the possibility of replicating hedge fund performance using composites of market benchmarks. But it is the most recent research, including a paper from Massachusetts Institute of Technology finance professor Andrew Lo and Jasmina Hasanhodzic, an MIT Ph.D. candidate -- first published in Institutional Investor's sister publication, Alpha ("Attack of the Clones," June 2006) -- that has finally spurred securities firms into action.
Goldman, Sachs & Co. and Merrill Lynch & Co. are the first two to put academic theories on hedge fund cloning to the test. Both have products that they contend can deliver hedge-fund-like returns without investments in hedge funds. Using factor models similar to those proposed by academia, their indexes analyze historical monthly hedge fund returns and use weighted baskets of market indexes to replicate them.
Sure, one hears the argument from Hedge Fund investors that the S&P 500 isn't the appropriate benchmark for their pet investments. And one wonders what such people think the purpose of their investments might be.
...hedge funds are marketed as an “asset class” that provides generous returns during all stock market environments and thus serves as excellent diversification for an all-equity portfolio. The funds have attracted close to $1 trillion of investment capital.
We showed that the practice of voluntary reporting and the backfilling of only favorable past results can cause returns calculated from hedge fund databases to be biased upward. Moreover, the considerable attrition that characterizes the hedge fund industry results in substantial survivorship bias in the returns of indices composed of only currently existing funds.
Why pay 1% in annual expenses for a dubious clone of a dubious hedge fund when you can pay a fifth of that and usually get better returns?