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It is possible to enjoy the benefits of hedge funds without such unpleasantness. Several new hedge fund replication strategies provide all of the pros without the cons—or so those marketing the strategies would have you believe. In the past year, a number of fund managers and leading banks, including Merrill Lynch and Goldman Sachs, have launched replication products, sometimes referred to as hedge fund clones or alternative beta products, that attempt to replicate hedge fund returns by putting in place relatively simple investment strategies using very liquid securities such as futures, shares and bonds.

"We’ve found that you can do an incredibly good job of modeling the broad hedge fund indexes using a portfolio of simple instruments, such as the S&P 500 and Russell 2000 index tracking products, the dollar exchange rate, and fixed-income instruments," says Jerome Abernathy, the chief investment officer of New York–based Stonebrook Capital Management, which launched a hedge fund replication product, the Stonebrook Alternative Beta Fund (SABF), last summer.

Using a portfolio of seven liquid financial instruments—four broad equity market indexes (S&P 500, Russell 2000, Euro Stoxx and MSCI Emerging Markets) and three nonequity index instruments (Treasury notes, Treasury bonds and the dollar)—Stonebrook tries to replicate the returns of the HFRI Fund Weighted Composite Index, a well-known hedge fund index designed to track the average performance of 2,000 different funds. The firm analyzes the HFRI’s performance figures over the previous two years, comparing them with the equivalent numbers for each of the seven individual instrument indexes, or risk factors. It then puts a percentage figure on each factor for how much of the HFRI index’s return over a particular month can be attributed to that particular factor. As Abernathy puts it, the factors have been "screened for explanatory power."

Although a hedge fund replication strategy is complex, it starts from the simple premise that much of the hedge fund industry’s returns can be replicated by going long or short in a combination of markets at a particular time. So as a purely hypothetical example, in one particular month Stonebrook’s analysts might conclude that the returns from the HFRI index could have been roughly replicated with a portfolio that was allocated 50 percent long on the S&P 500, 20 percent short on the Russell 2000 and 5 percent long on Treasury notes, plus smaller allocations to emerging market equities, broader global equities and even the dollar. Such a portfolio could be run on a month-to-month basis with the weightings between factors rebalanced as new data becomes available. Abernathy says that, gross of fees, the strategy can explain 75 percent of hedge fund returns.

The SABF has an annual 1.5 percent flat management fee, which is far superior to the infamous hedge fund 2-and-20—a 2 percent annual management fee plus 20 percent of any profits. Investment banks, which use a similar replication methodology, typically offer access to the strategy in derivative-note format, where there is no standard fee structure, but investors can still expect a substantial savings over traditional hedge fund investing.

One or Many?
For critics of these strategies, the danger lies in the fact that there is no single accepted method for replicating hedge fund performance. The method that Stonebrook and the banks use is called a factor model. However, there are two other methods commonly used for achieving the same result. One of these, generally referred to as primitive trading strategies, is used by the Swiss fund-management company Partners Group. Its method does not attempt to replicate index hedge fund returns, but rather identifies the types of obscure market returns that hedge funds specialize in and then puts in place mechanical strategies that will harness them, too.

Harry Kat, a professor at London’s Cass Business School, developed the third common strategy, which is just becoming commercialized. Kat’s method differs from the other two in that rather than trying to replicate hedge fund returns in a vacuum, he takes an investor’s existing portfolio (with stocks, bonds, cash, etc.) and then, using liquid instruments, creates a segment that statistically looks like an allocation to hedge funds. Simply by using futures, regular equities and bonds, and other liquid instruments, he creates a product structure that gives the returns of hedge funds but is not correlated with the rest of the investor’s portfolio.

In other words, he tries to harness the diversification benefits of hedge fund returns (which are not linked to the broad performance of the financial markets as the rest of the portfolio is). As Worth went to press, he had just signed a licensing agreement with the investment company New Wave Asset Management, which plans to launch a commercial version of Kat’s service called FundCreator.

Not surprisingly, Kat is no fan of the competition’s methods. "Hedge funds by their very nature are extremely dynamic, and you can’t capture that with one of these factor models," he says. Any performance benefits an individual manager might have—the raison d’être of hedge funds—are diversified away, leaving just normal market returns, he argues. "The HFRI composite index is highly correlated with the S&P 500. Are you as an investor interested in something like that?" Not if you want absolute returns, he says. From Kat’s point of view, the factor-based products that banks offer are just packaging up the same kind of returns everyone already gets through their traditional investments.

Kat’s competitors obviously disagree, and claim they offer alternative returns at small cost and in a transparent way. Who’s right? Maybe both are, but at this stage, nobody is sure. Hedge fund clones are brand new and—at least for the time being—unproven.

John Ferry is an Edinburgh, Scotland–based financial writer and a senior correspondent for Worth.