The Case Against Hedge Fund Replication

Liquid, transparent, and cheap—what’s not to like about hedge fund replication? A lot, consultants argue.

(June 28, 2013) — Hedge funds are fine, some fund-of-hedge funds are OK, but Hewitt Ennis Knupp has urged investors to think twice before committing to an approach that replicates any of the above.

In a recent paper, the consulting firm outlined its various grievances against hedge fund replication products, which were propagated on the back of the main industry’s popularity.

These objections included high correlations to equity markets, poor performance relative to the hedge funds they are meant to track, and little or no alpha creation.

The paper said the very starting point for these products was “flawed”.

Although the products are relatively cheap-many do not charge performance fees-investors are being subjected to a false economy, the paper said.

“No replicator has managed to match the net-of-fees performance of arguably the two most common benchmarks used for hedge fund performance, the HFRI Fund Weighted Index or the Dow Jones Credit Suisse Index,” the paper showed.

It admitted that replicators had performed better than one investable index with daily liquidity, but this benchmark also had a number of idiosyncrasies. “In our opinion, the restrictions placed on inclusion in this index…mean that this index is by no means representative of the performance of the ‘average’ hedge fund.”

The replicators’ lower fee level, cited as between 0.5% and 1.6% compared to the oft-quoted 2-and-20 charged by many in mainstream hedge funds, was not a good enough carrot for investors.

The increased liquidity offered by these products is unnecessary for most institutional investors, so should not be seen as a boon, the paper said. The consultants added that due to the pressure the mainstream hedge fund industry had come under for better transparency, claims that hedge fund replicators offered a better view were becoming baseless.

“We do not recommend the use of hedge fund replication products as strategic investments, at least in their current form,” the paper concluded. “Proponents of hedge fund replication will cite various factors that supposedly make this approach a sensible alternative to direct hedge fund investing, but the arguments don’t really stand up to scrutiny.”

One bright spot for those creating such products: “One area where replication could be useful is as part of a transition management program, as a placeholder prior to investment in a hedge fund for example. However, due to the dispersion of returns, great care and research would be needed prior to any investment.”

Hewitt Ennis Knupp advised investors that if they wanted hedge fund exposure, they should go for the real thing.

The prosecution rests.

To read the entire paper, click here