The world of hedge fund replication has in the past left us a little flummoxed. But having ploughed through the seventh instalment of Harry Potter on the day of its release, we’re pretty darn confident we can take on all comers when it comes to analysing the adventures of the boy wizard.
So there was much delight when we happened across a blog posting combining just these two topics. Clarity would be ours at last, surely?
Guest blogger Tammer Kamel from Iluka Hedge Fund Consulting, at All About Alpha, writes that if hedge funds are market wizards, then the clones are muggles looking for Hogwarts. Thus far they don’t seem to have found the school - nor have they discovered the chamber of alpha. But, he adds, their efforts are nonetheless valuable to investors. Kamel says:
Hedge fund replication is not wizardry at all of course, it is an elegant application of quantitative finance which I find intriguing, albeit for the wrong reasons.
The right reasons would be a hedge fund product at a lower cost, with more transparency, scalabilty and so on - which is all desirable provided the clone meets the requisite level of expected returns. Alas not, says Kamel.
The cloning techniques I have thus far encountered aim to emulate what hedge funds actually do as opposed to what they are supposed to do. This is a consequence of taking the performance of the hedge fund collective as their replication objective. But the performance of the collective, or equivalently the average hedge fund, is actually not good. Thus replicating the average hedge fund is no use to me since the average hedge fund is a bad investment.
A fiendishly complicated piece of research by Edhec Risk released in June, and summarised here by All About Alpha, concluded that replication was overall a “work in progress,” with both a factor-based approach, which aims to replicate hedge fund returns precisely, and the pay-off distribution approach pioneered by Professor Harry Kat, which aims to produce a similarly distributed set of returns to hedge funds. Both approaches have shortcomings and fail to generate satisfying results, says Kamel.
All this raises two points, he adds. First, if, as some claim, a large fraction of hedge fund returns can be explained and replicated by a set of passive, traditional investments it should not drive investors away from hedge funds and towards clones. It should drive them out of the ball-park all together.
Secondly, he argues that the challenge of replicating hedge fund returns forces investors to ask what they actually want from hedge fund investments.
Answer: they want the dream. Professor Kat’s method generated what Edhec called “relatively satifying results,” but was not considered to be a method suitable for replication - “at least not in a sense likely to meet investors’ expectations”. But Kat has argued that in committing their funds to gaggles of alpha-incapable managers, the most investors can desire of their hedge fund portfolio is a skewed risk-return profile.
“The problem remains that, in my 12 years in the industry, I have yet to meet an investor demanding better kurtosis from me,” says Kamel. In other words investors want it all - full-blown alpha, thank you.
Kamel concludes:
The wizardry of a good hedge fund is and always has been alpha. The fact that most can’t produce it, is no reason to excuse clones from seeking it. If cloning alpha is impossible then cloning is futile. But there are replication techniques that are beginning to attempt to clone actual strategies instead of just the mediocre performance of the hedge fund collective.
Great. Excellent. And the horcruxes fit in how?
