Alternative investment firm Evanston Capital Management has published a report examining the intricacies of hedge fund replication strategies.
Recognising the investment community’s significant interest in hedge fund replication and related topics such as alternative beta, the report – Hedge Fund Replication: Is It Appropriate For You? – takes an in-depth look at these complex attempts to mimic the core risk and return properties of certain hedge fund strategies within a more accessible investment form than traditional hedge fund investing.
The paper discusses the two primary types of replication, “top down” and “bottom up,” reviews how replication can help improve manager underwriting and monitoring, looks at the issue of liquidity rights, and discusses expected changes in investment returns given the growing proliferation of replication products.
“Hedge fund replication offers lower fees, greater liquidity and enhanced transparency compared with certain traditional hedge fund strategies, so it’s not surprising it has received a lot of attention among financial professionals and investors,” says Peter Hecht, vice president, senior investment strategist, Evanston Capital Management. “That said, replication products come in a variety of forms, are often difficult to understand, and are not appropriate in every investing situation. They therefore warrant a close examination to help investors better understand the role of replication in a larger hedge fund programme.”
The report discusses the debut of replication a decade ago in the form of a top down, regression based approach in which replicators recommended investing in a handful of capital market risk factors instead of the underlying hedge fund strategies. Given inherent weaknesses, including an often-lower average return and a high correlation with traditional stock and bond markets, the top down method was not widely adopted.
The next iteration of replication, the bottom up, security level approach, attempts to understand the underlying securities and trading patterns of various hedge fund strategies. If certain strategies have little or no discretion in what and how they trade, the bottom up approach “replicates” the strategy using a similar set of systematic trading rules. The report notes that some strategies are too discretionary and/or illiquid to duplicate and so are not appropriate for replication.
“The bottom up approach has gained popularity over the past few years and for a specific subset of strategies can be a legitimate alternative to a traditional hedge fund manager,” says Hecht. “While there are a limited number of top down products available, given their limitations, we do not recommend their use in a larger hedge fund program.”
According to the report, replication products should especially be considered when there is little expected added value from using a manager and/or there is a significant need for short-term liquidity. The report also notes that “not all bottom up replication products are created equal,” and recommends conducting thorough due diligence to determine the product that best meets a portfolio’s overall objectives. While recognising the improved liquidity of a bottom up approach is desirable, the report counsels investors to make certain the liquidity terms of the investment vehicle are consistent with the liquidity of the underlying assets and strategy. In addition, the report cites the need to be mindful that a replication strategy that is publicly accessible will have different risk and return properties than the original, private hedge fund strategy on which it is based.
“Investing the time to understand bottom up replication approaches will aid the manager underwriting and monitoring process,” says Hecht. “In considering hedge fund replication products, it’s important to have realistic risk and return assumptions and to remember many hedge fund strategies can be difficult to duplicate. Strategies prone to replication, whether accessed via a bottom up replicator or traditional hedge fund manager, should be a component, and not the entirety, of a larger hedge fund programme.”
“As experienced alternative investment managers, we have information and insights that we think are of interest to the investing community,” says Adam Blitz, principal, CEO and CIO, Evanston Capital Management. “We look forward to continue providing the marketplace with research and reports on timely issues in alternative investing.”