Do android hedge funds dream of alpha?
Hedge funds are the Rolexes of the investment world. Traditionally they have been available only to the wealthy. But as with any luxury product, imitators are never far behind. A range of funds claims to mimic the performance of hedge funds — minus the princely fees.
Hero worship of hedge fund managers has meant that cut-price copy cats are often met with skepticism. However, hedge-fund replicators have now started to prove their worth.
A recent study by Swiss academic Nils Tuchschmid showed that 13 of 20 clone products did better than the average hedge fund during the financial crisis. All also outperformed the Standard & Poor’s 500.
This should not come as such a surprise. A wealth of research suggests that many hedge funds now derive their returns as much from exposure to exotic risks and markets as to investment skill. MIT’s Andrew Lo has concluded that talent accounts for as little as a third of hedge fund returns. The rest comes from market risk.
Overcrowding makes it harder for managers to stand out. When hedge funds were a cottage industry feasting on abundant market inefficiencies, generating alpha was easier. Now with an estimated 9,000 funds, dozens or hundreds of managers may be pursuing the same strategy — cannibalizing each other’s alpha.
The replicators still have just $2 billion under management and will need a much longer track record before they can silence the doubters. They may also struggle to ape some hedge fund strategies — especially those investing in illiquid markets or demanding high leverage.
Even so, if their early promise is realized, the implications for the hedge fund industry could be profound. For the first time hedge fund-style strategies would become available to Joe Public — reducing retail investors’ almost total dependence on stocks.
Many traditional hedge fund clients may also be tempted to defect, lured by the low fees, full liquidity and robust regulation offered by the clones.
Truly talented managers have little to fear. But no investors should be paying a 20 percent performance fee and enduring lockups just for exposure to exotic markets.