P&I Article: What every allocator needs to know about hedge fund replication

From guest contributor Andrew Beer:

In the current heated debate on hedge funds, there’s no middle ground. You’re either pro or con, in or out, red or blue.

But this is, frankly, stupid. Hedge fund proponents make legitimate points about diversification, but fail to acknowledge where they’ve been flat-out wrong on many issues (e.g. wishful thinking that alpha would adequately cover fees). Likewise, the “out” camp is correct that fees are egregious, but offer no credible alternative. Redeem from hedge funds and invest in … bonds with negative yields? Equities at the tail end of the second-longest bull market in history?

The “hedge funds or bust” mantra of the “pro” camp assumes that hedge funds have some secret recipe for generating alpha, and the only way to get it is by throwing more money at high-cost illiquid hedge funds. This feels a bit … 2006. The simple truth is that what hedge funds do is not all that mysterious — they (primarily) invest in the same stocks, bonds and other asset classes as everyone else — and a lot of smart people have spent the past decade studying hedge funds to understand how they make money, what they do well, and how to offer investors the benefits (diversification) without excessive fees and illiquid, investor-unfriendly vehicles. For a lack of a better term, this movement is called “hedge fund replication,” when it really should be called something like hedge fund “distillation.”

For allocators and investors, we’ve put together a cheat sheet on the two primary approaches: top-down and bottom-up.

Click here to read the full article.

October 6, 2016