What do convertible arbitrage, distressed debt, long, short, and global macro managers all have in common? The answer according to Professor Narayan Naik, speaking today at the Middle East Investment Conference in Qatar, is exposure to a series of shared risk factors. Naik has devoted the last decade to the study of the factors that these managers have in common, rather than falling for the sales pitch that each strategy is unique.
Through a mammoth effort, he and his colleagues, Daniel Edelman, CFA, William Fung and David A. Hsieh have collated a giant database of hedge fund returns that is more representative than many available commercially. Within this database they searched for common factors that could explain hedge fund performance. According to Professor Naik when hedge funds are put into buckets a pattern emerges that can be explained in terms of equity risk, large cap/small cap spread risk, and credit spread risk.
This may sound like many other attempts to create a multi-factor model, however, the difference is that Professor Naik’s attempt appears to have worked. He presented model returns that looked uncannily like the returns of many hedge fund indices. Naik has essentially created a hedge fund clone that can apparently replicate the performance of hedge fund indices, at least in theory.
Naik’s analysis gives us a workable definition of beta in a hedge fund context; from traditional equity type betas through to exotic betas that are encapsulated by exposures to the specified risk factors. What is left as alpha is the extra return achieved on top of the returns to all of these risk factors.
To illustrate this concept, Naik used the image of an iceberg. Alpha is the very smallest part that is visible above the waterline but this is not the alpha that most investors are paying performance fees for right now. His view is that the typical practice of a measure of alpha benchmarked against LIBOR+x% is just plain wrong for many hedge funds. This prompts an intriguing thought: why pay 2+20 for a hedge fund if you can get the same performance more cheaply via a “clone,” or to give it its technical name, a replication strategy?
Another startling revelation was the result of Naik’s analysis of hedge fund returns by manager size. Based on his clone as a benchmark, manager alpha was assessed according to the value of funds under management. A very pronounced U shape (or “smile”) was observed. In other words, small scale and large scale managers seemed to generate alpha, mid-size managers seemed to be in negative alpha territory. When asked to explain this, Professor Naik suggested small managers may represent hungry and youthful talent working in innovative areas, while the “big boys” may be benefiting from economies of scale in purchasing and technology, at least over the time period studied.
While investable versions of the hedge fund clone concept are available, Professor Naik readily admits he is not in the hedge fund sales business. He wants his work to be used to inform investors about what they are really paying for. A performance fee should be for genuine outperformance (i.e. alpha) and not for beta-type returns that could be generated by anyone. Naik warned that investors should watch out for “a sheep in wolf’s clothing,” meaning a fund that charges hedge fund-level fees while offering beta-type performance.
What next for investors? Naik believes that obvious next steps for investors include core-satellite approaches where clones are used to replicate exposures to exotic betas, and individual managers are selected on the basis of genuine alpha production. Add to this single strategy clones and the next generation of replications will include a multi-strategy allocator that switches strategy based on pre-set indicators. Professor Naik and his colleagues are working on this right now. Sounds like the revenge of the clones after all.