Dr. P.V. Viswanath



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The Hedge Fund 'Clones'

Wall Street Concocts Products With Fewer Barriers, but Will Returns Match?
By ELEANOR LAISE, Wall Street Journal, July 21, 2007; Page B1

Trying to cash in on investors' fascination with alternative investments, Wall Street is pitching a complex new product that aims to mimic hedge-fund performance while avoiding the gigantic fees that real ones charge.

Many financial experts, however, say the new product -- known as a "synthetic" or "clone" hedge fund -- is unproven and could be risky for investors.

The clones, being launched by firms including Merrill Lynch & Co., Goldman Sachs Group Inc. and J.P. Morgan Chase & Co., aim to generate returns comparable with hedge funds without the usual hedge-fund drawbacks such as lengthy "lockup" periods that tie up investors' money for a year or more. Fees, often around 1%, are well below those of traditional hedge funds, which typically collect a 2% asset-based fee and 20% performance-based fee.

Hedge-fund clones are "a natural evolution in the market," says Paul Brakke of State Street Global Advisors, a unit of State Street Corp., which is developing clone products. Goldman recently started offering its Absolute Return Tracker clone to wealthy individual and institutional investors, and Deutsche Bank AG this year launched clone products based on an index it recently developed.

Currently, tools like these are being pitched largely as a kind of index fund for the yacht-club set. Some literally try to track indexes of hedge-fund returns, while others have more complicated formulas.

In the next few months, smaller investors are likely to see more versions of these investments aimed at them. IndexIQ, a Rye Brook, N.Y., investment firm, plans to launch separately managed accounts using cloning strategies with a $100,000 minimum investment. The barriers to invest in regular hedge funds can be much higher.

Also planned: a mutual-fund or exchange-traded fund from Stonebrook Structured Products LLC of New York, mimicking the firm's clone fund that currently has a minimum $250,000 investment.

The products raise a host of concerns for investors. Since hedge-fund clones are so new, they have scant real-world return data to support their claims. Many academic researchers say the products will likely have trouble delivering hedge-fund-like returns.

Among the few hedge-fund clone products to have a substantial real-world track record are two mutual funds from Rydex Investments that were issued in 2005. Last year the two had returns of 6.6% and 8.4%, respectively, below the 12.9% returned by HFRI Fund Weighted Composite Index, a popular hedge-fund index. Rydex says that one-year performance is too short a period from which to draw conclusions.

While investors generally turn to hedge funds to diversify their portfolios, recent research suggests the clones may behave much like the broad stock market and won't provide much protection when stocks tumble.

"The jury is out, and there's not enough evidence to convince me these [current] models are capturing the dynamics of the [hedge-fund] industry," says William Fung, a visiting professor of finance at London Business School who is working with J.P. Morgan and State Street on new clone models.

Hedge funds, which are private investment pools for wealthy and institutional investors, have attracted heaps of cash in recent years. The funds collect high fees to pay their managers, and often hold hard-to-trade investments such as private companies and timber.

By contrast, clones trade-more traditional assets, such as stocks and bonds, and can generally be bought and sold daily or weekly.

Here's how the most common type of hedge-fund cloning, known as the factor model approach, works: Firms analyze a few years' worth of hedge-fund returns, often using data from hedge-fund indexes. The firms then essentially reverse-engineer those returns, using complex mathematical models to create a portfolio of easily traded investments that would have delivered the hedge funds' performance over that period.

That group of investments becomes the clone's portfolio for the next month. Then the process is repeated, typically each month, and the portfolio is revised.

Firms offering clones generally acknowledge that the products can't deliver the returns of the best hedge-fund managers.

Some firms make more ambitious claims than others. Merrill Lynch says its Factor Model clone should deliver the full, after-fee returns of the average hedge fund, as tracked by the HFRI Fund Weighted Composite Index. But Goldman Sachs's Absolute Return Tracker "is not really expected to track hedge-fund returns that closely," a spokesman says. Rather, the product's performance over time should "broadly resemble" hedge-fund returns, he says.

Some experts doubt even that goal. A recent study of cloning by researchers at France's EDHEC Business School showed that most clones generally did a poor job of mimicking the returns of hedge funds.

A possible reason: Hedge funds are adjusting their portfolios all the time, whereas factor-model clones are based on previous years' hedge-fund returns, says Lionel Martellini, a co-author of the study.

"It does come as a little bit of a surprise to us that the industry very suddenly started to launch products" cloning hedge funds, Mr. Martellini says. The clones, he says, are "very much a work in progress."

Andrew Lo, a finance professor at Massachusetts Institute of Technology whose research helped to spark clone products, says he has found that the clones will capture only about 40% of hedge-fund returns. One reason: Some hedge funds are especially hard to mimic, such as those that try to profit from events such as corporate bankruptcies, because they often hold hard-to-trade securities that are off-limits to clones.

And some clones may not provide the diversification that investors seek in hedge funds, according to recent research by Harry Kat, professor of risk management at Cass Business School at London's City University. The clone products offered by the big Wall Street firms generally behaved much like the S&P 500 index in recent years, he says.

Mr. Kat markets a competing approach to cloning that doesn't aim to match returns but instead tries to mimic typical hedge-fund characteristics, such as low correlation to broader markets.

Despite their possible limitations, the clones may still have some advantages over hedge funds, experts say. In addition to lower fees and ease of trading, the clones offer transparency: Investors generally know what is inside a clone's portfolio, whereas traditional hedge funds can be secretive about their holdings.



  1. How do hedge fund clones work? That is, how does a hedge-fund clone manager decide what to buy and sell?
  2. Why might you think that hedge funds earn more on a risk-adjusted basis than other investment products?
  3. Does the performance of hedge funds demonstrate market inefficiency?