Institutions typically aren’t interested in the usual hedge fund investment strategies because they don’t support their needs for transparency, liquidity, low fees and substantial capacity. And hiring hedge fund managers requires a significant amount of due diligence, both upfront and on an ongoing basis.
For these reasons, two new investment strategies relating to hedge funds—short extension and hedge fund replication—are swiftly gaining prominence in the marketplace, offering institutional investors a chance to explore the world of hedge funds without the restrictions and commitments of traditional hedge fund investing. Here’s a brief overview of these strategies and their advantages.
1)Short Extension
Short extension is the institutional investor’s first major influence on hedge fund investing, as it captures the institution’s need for transparency, liquidity, low headline risk, reasonable fees and benchmark orientation. You might think of it as “hedge funds with training wheels.”
The greatest attraction of short extension is the expanded opportunity set it creates and how this can translate into better performance. By relaxing the short constraint, managers can enhance negative bets against stocks in their benchmarks— from simply not owning them to actually taking short positions against them—allowing for a significant increase in active risk that could potentially lead to higher returns.
One key advantage to short extension is that it increases leverage in the equity portfolio without magnifying risk. In fact, the opposite is true: the leverage embodied in short extension increases the opportunities for diversification, which ultimately leads to greater risk control.
Short extension is the hottest new trend in the institutionalization of hedge funds—it’s estimated that $60 billion has been invested this way in 2007 alone. Estimates from Merrill Lynch and State Street suggest that this number will increase dramatically within the next three years to anywhere from $500 billion to $1 trillion.
2)Hedge Fund Replication
Hedge fund replication arises from recent academic research by Fung & Hsieh and Andrew Lo, among others, suggesting that much of the hedge fund return is related to beta(how markets perform)instead of alpha(added value above and beyond market performance).
Investment firms have realized that they can recreate or replicate hedge fund returns for aggregate hedge fund indexes with a reasonable level of accuracy. Called “factor replication,” this is the most common form of hedge fund replication. However, since the return patterns that are being replicated are after-fee indexes—which are highly diversified and therefore highly correlated to equity and credit markets—some professionals question the value of this strategy.
The second, but just as controversial, form of hedge fund replication is called “distribution replication.” Distribution replication recreates the variance, skew and kurtosis of a distribution, as well as its correlation to a reference portfolio. The investor cannot specify a mean return, but must accept what the capital markets deliver. However, by loosening the constraints that factor replication imposes, distribution replication allows investors to tailor return distributions to meet their needs.
The increasing prevalence of short extension and hedge fund replication shows the enormous influence that institutional investors are having, and will continue to have, on the evolution of the hedge fund business. No doubt there will be other such strategies down the road as they plant a firmer footprint in this realm.
Tristram S. Lett is managing director, Alpha Beta Strategies, at Integra Capital Limited. tlett@integra.com
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