Druckenmiller nailed the Treasury short. 
Andurand dialed up his long crude oil bet.
Maverick caught the value rotation early.
Allocators have long been in thrall with near mythic hedge fund language. Over the past decade, though, the esoteric investment sorcery of hedge fund stars has been demystified by a simple strategy that efficiently replicates hedge fund playbooks – without the exorbitant fees attached. These funds, called ‘factor-based hedge fund replication’, stand to transform the hedge fund industry as profoundly as passive products changed the mutual fund world.
To back up: in 2006, academic legend Andrew Lo of MIT posited in a paper that statistical risk models, a variant of those developed by Nobel laureate Bill Sharpe, could determine with striking accuracy how a portfolio of hedge funds was positioned across major asset classes.
Simplistically, owning small/value stocks and shorting large/growth ones during the dotcom crisis drove returns; this stock or that stock, not so much. The key was once you knew how hedge funds were positioned, you could transform this ‘risk model’ into an investment product: just buy low cost, liquid instruments like futures contracts to mimic the same exposures. When they change their minds, you rebalance the portfolio. Startlingly simple and cheap, yet very effective.
There was one small problem: everyone in the hedge fund establishment hated it.
And for good reason. Built on mystique and inaccessibility, the industry scorned the idea of a toy robot dog keeping pace with, let alone outracing, a stable of hand-picked greyhounds. Even worse, replication raised thorny commercial questions, such as why any rational person (or better yet, a fiduciary) would invest in an illiquid fund of hedge funds with 5% annual fees once presented with a daily liquid version with 80% lower costs. Not surprisingly, the establishment circled the wagons.
The stories are quite incredible. A $10bn fund of funds ran a secret replication programme internally, only to shut it down because it ‘worked too well.’ Academics-for-hire wrote disingenuous papers disparaging the concept. Banks steered clients to products that made money for everyone but investors. Consultants wrote papers soon disproven by evidence, yet failed to correct the record.
Thankfully, a new generation is taking over the wealth management space.
The young guns grew up in a world where an index is a powerful and efficient tool, not a threat. Their clients largely invest through more accessible UCITS funds, and fees matter – to both them and their clients. They have watched the prior generation’s self-serving myths – e.g. the infallible hedge fund genius – wither in the face of reality. They recognise that ‘active’ and ‘passive’ can intelligently coexist: Millennium, the Sharpe ratio machine, may be a brilliant choice for a few elite clients, but an accessible, liquid, ‘index-like’ product is far better suited to the other 99%.
Through the lens of model portfolios and faced with dire predictions for 60/40 portfolios, they understand the value of efficient, predictable ways to get exposure to sophisticated and diversifying stategies.
The evidence is indisputable. In UCITS land, there are three ‘pure-play’ factor replication products with track records through the rolling crises of the past several years. Each has its own design nuances, but all get the job done: to roughly match the performance of actual hedge funds with high correlation. Relative to UCITS version of hedge funds – designed for the everyman but too often expensive, watered-down versions of the real thing – replication products consistently rank among the best performers and least expensive. Sometimes, you can have your cake and eat it too.
There are, of course, plenty of things that cannot be replicated this way – never try to replicate Citadel Wellington, or PE-like distressed managers, or plenty of esoteric, capacity constrained strategies. If you want that, buy the real thing. But where replication works – hedge funds overall, equity long/short and managed futures – it can work beautifully.
For allocators, then, the toolkit expands and they can decide when to pay high fees and bear illiquidity, or when the low cost, liquid index approach should win out. Whether revolutionary or evolutionary, it certainly represents progress.
Andrew Beer is a managing member at Dynamic Beta Investments. The views expressed above should not be taken as investment advice.