First, in our opinion, investors are even more concerned than ever about capturing alpha and ensuring that their current portfolio investments in hedge funds and fund of funds are producing the expected results. As more and more traditional hedge funds come under pressure, investors are likely asking how they can maintain their desired and, in many cases required, allocation to alternatives and hedge funds under current negative conditions.

Second, many investors are mandated to invest a portion of their portfolio in hedge funds and other alternatives. This has always presented a dilemma: How do investors locate good hedge fund and hedge fund of fund managers? It requires a lot of effort and expertise to evaluate a hedge fund and fund of fund and historically, many of the best ones have been closed to new investors due to capacity issues.

Increasingly, the answer to these questions has been hedge fund beta replication strategies. They can form a core hedge fund holding for institutional investors, allowing institutional investors to identify their true sources of alpha and complement those holdings with liquid beta. They also have the added benefits of unlimited capacity, liquidity and transparency, all key benefits in today’s investment environment for both institutional and retail investors alike.

What is hedge fund Beta replication?
Although its origins lie in the academic literature on hedge-fund alphas and betas, it has spread quickly into practice, with new hedge-fund beta replication products sprouting up almost monthly, and several professional conferences devoted to the subject. From the pace of these developments, one could easily assume that the industry need has been clearly established.

In fact, hedge-fund beta replication is more accurately described as an elegant solution in search of a problem. The industry has skipped over the question of why any investor would be interested in replication, and has, instead, jumped to debates about which replication technique is best, what kind of instruments should be used, and whether to use a ‘top/down’ or ‘bottom/up’ approach. We are unlikely to resolve any of these debates if we do not start with a clear idea of the specific problem that hedge-fund beta replication solves for the investor.

In particular, hedge-fund beta replication is neither better nor worse than direct investments in hedge funds. It is simply different because replication strategies trade off the full return of hedge funds for improved transparency, liquidity, capacity, and fees. To understand the practical relevance of replication products, we consider five distinct challenges for which the hedge-fund beta replication might genuinely add value.

1. Transition management
Since the largest funds of hedge funds are $5 to $10 billion in size, and can place only $1 to $2 billion each year in new capital, it would take several years for large institutional investors with, say, $20 billion to achieve a new 15 per cent ($3 billion) allocation to alternative investments. The opportunity cost of spreading out this allocation over time can be substantial, with potentially adverse consequences for the funded status of the pension plan as well as its asset/liability mismatch.

For large shifts in allocations among traditional investments, institutional investors have employed dedicated managers to facilitate the process of moving from one set of portfolio weights to another.

This transition manager might use index funds or futures to provide the pension plan with immediate exposure to broad-based factors of the new portfolio, e.g., large-cap value or small-cap growth, and these temporary investments would be unwound and transitioned over time as active managers were identified and approved by the plan sponsor.

In much the same way, hedge-fund beta replication strategies can provide immediate exposure to the diversification benefits of ‘alternative betas’ and are easily unwound as particular hedge funds and funds-of-funds are selected. The customisability of replication strategies gives investors great flexibility in tailoring the transition process to their specific investment objectives.

2. Capacity
For the world’s largest private banks and sovereign wealth funds, implementing allocations to hedge funds that are big enough to materially impact their overall portfolio’s risk and return is a challenge.

Since many of the best managers are closed or capacity-constrained, these ‘mega’ investors must spread their allocations across many funds to find the capacity they need; hence, it should come as no surprise that the resulting returns look more like industry averages rather than the 30 or 40 per cent returns earned by superstar hedge-fund managers.

Therefore, a liquid, high-capacity, low-fee, hedge-fund beta replication strategy may be a compelling alternative for capturing the diversification (correlation) benefits of hedge funds, even if it lacks the outsized alpha of the industry’s elite managers.

3. Liquidity management
Many institutional investors may find that the magnitude of their desired hedge-fund allocation is inconsistent with the percentage they are willing to allocate to illiquid investments. Hedge-fund beta replication strategies enable plan sponsors to mix and match with more traditional hedge-fund strategies to create a customised blend of alpha, beta, and liquidity.

Replication strategies provide large investors with a powerful tool to manage their liquidity, either to avoid unwinding illiquid hedge-fund positions at inopportune times, or to create a strategic liquidity pool within their alternative investment allocations to exploit investment opportunities created by liquidity events such as August 1998 and September 2001.

4. Broader diversification benefits
At the May 2003 hedge-fund roundtable discussion hosted by the US Securities and Exchange Commission, one of the commissioners asked a panel of hedge-fund managers whether the typical hedge-fund investment was safer or riskier than traditional investments.

One manager responded by comparing the performance of an equity market-neutral hedge fund to that of a long-only technology mutual fund in the aftermath of the Internet bubble, and concluded that the ability to hedge market risk by engaging in short sales gave hedge funds a decided advantage. The commissioner followed up by asking why the current regulatory regime reserved such a useful investment option only for institutions and the very wealthy. Hedge funds offer powerful diversification benefits to large investors, but remain largely unavailable to retail investors.

Beyond the regulatory obstacle of publicly offering a privately placed security, one of the biggest challenges in bringing the diversification benefits of hedge funds to retail investors is providing them with the liquidity and transparency they expect. Hedge-fund beta replication offers an ideal compromise: diversification benefits similar to hedge-fund investments, with daily liquidity and transparency similar to mutual funds.

5. Customisation
One of the least discussed and most significant benefit of hedge fund beta replication strategies is the ability to customise these strategies to meet the needs of a particular investor. Managers offering these strategies can work with investors to analyse their current hedge fund and fund of fund holdings and determine how these correlate to their overall portfolio. This is particularly valuable in this current period of market volatility where portfolio diversification is key.

One limitation of current portfolio analytics is that traditional asset-classes and hedge funds are treated like apples and oranges. An institutional or high net worth investor may allocate 15 per cent to alternatives under the simplifying assumption that alternatives are a unique asset class with a risk premium distinct from the stocks and bonds in the traditional portion of its portfolio. However, alternatives consist of multiple risk premia, some of which overlap with those of traditional assets.

For example, the long/short equity style category accounts for as much as 60 per cent of the assets in all hedge-fund strategies. A portion of its expected return is attributable to the same equity beta as in the traditional portion of an investor’s portfolio. Hedge-fund beta replication allows investors to customise their alternatives exposure, by either neutralising excess exposure to common factors, or creating such exposures inexpensively through replication.

As we face an increasingly difficult investment climate, the choices that investors make or don’t make will become magnified and portfolio diversification and knowledge will become increasingly important. Hedge fund beta replication strategies offer investors another tool in their toolbox to assist them in navigating through these challenging times.

Disclosure: The opinion and analyses in this article reflect the subjective judgments and assumptions of the authors at the time this article was written and do not constitute an offer of services, nor an offer or recommendation to purchase or sell shares in any security.

Jeremiah H. Chafkin and Andrew W. Lo are, respectively, the president and chief scientific officer of AlphaSimplex Group, LLC, an investment adviser registered with the US Securities and Exchange Commission. AlphaSimplex Group products are distributed in the Middle East through Natixis Global Associates.