Hedge Fund Replication is Gaining in Popularity, but is it a Viable Alternative to Hedge Fund Investing?

The turbulence of 2008 refocused the attention of hedge fund investors on three principal areas (in addition, of course, to performance): liquidity, transparency and fees.  In general, investors are demanding, as a condition of new or continued investment, greater liquidity, enhanced transparency and lower fees.  See “Hedge Fund Managers Grapple with Legal and Practical Consequences of Demands from CalPERS, URS and Other Pension Funds for Better Investment Terms and Separate Accounts,” Hedge Fund Law Report, Vol. 2, No. 14 (Apr. 9, 2009).  However, to the extent managers give ground in any of these areas, their performance and operations can be complicated: enhanced liquidity can undermine the viability of longer-term investments; increased transparency can threaten the confidentiality of investment strategies; and lower fees can make it harder to attract and retain the best talent.  Investors still want access to hedge fund strategies – hedge funds as a group outperformed the broad equity indices in 2008 by a significant margin – but many have become skittish about traditional hedge fund structures.  Hence the growing popularity of so-called hedge fund “replication” strategies and funds.  Such hedge fund replication funds generally are registered investment companies that invest in liquid securities with the goal of tracking the performance of a group of hedge funds.  On the plus side, such funds generally offer daily liquidity, daily or frequent transparency and low fees (relative to traditional hedge fund fees).  On the negative side, they offer – or purport to offer – beta as opposed to alpha.  That is, they offer the returns of the hedge fund herd, as opposed to the returns of a star manager.  (By the same token, they generally avoid, or at least mitigate, the fallout from investment in a poor-performing or even fraudulent manager.)  In addition, the jury is still out on the ability of certain replication funds to faithfully track hedge fund indices by investing exclusively in liquid securities.  Nonetheless, interest among hedge fund investors and others in hedge fund replication is robust and growing.  We offer a comprehensive analysis of the pros and cons of hedge fund replication, including discussions of: what hedge fund replication is and how it works; the main providers of indices used for replication products; advantages and drawbacks of investing in replication strategies; and how institutional investors such as pension funds characterize investments in replication strategies for allocation purposes.

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