At a CFA Institute risk-management conference at the New York Hilton this past February, Andrew Lo asked the audience of securities analysts to consider a performance history for a fund that looked too good to be true. Lo, a professor at Massachusetts Institute of Technology, didn't identify the manager or the strategy, but he displayed its extraordinary history: a 2,721 percent cumulative gain from January 1992 through December 1999. The S&P 500, by contrast, posted a 367 percent rise over that span--one of the better runs for equities in the 20th century. In addition, Lo's mystery strategy delivered its hefty gains in fairly consistent doses, suggesting that the run wasn't a fluke.
Was this a byproduct of some unnamed hedge fund genius? Or maybe it was just dumb luck, after all. Neither, as it turns out. Lo eventually explained that the remarkable return history was driven by an automated strategy that anyone could have produced. The secret was simply selling S&P 500 put options each month that were closest to expiration and out of the money by at least 7 percent. Although the strategy was easily replicated, it delivered spectacular results that any human manager would envy. So much for genius.
Indeed, Lo's presentation raised a number of questions about hedge funds and whether the high fees are justified. For instance, how much would you pay for the above options strategy? If you didn't know how the returns were generated, would you be likely to pay more or less for the results? How does that compare if you know how the results have been generated? And while we're asking questions, how easy would it be for a hedge fund manager to use such a strategy while telling the world he has a proprietary trading system that he can't really talk about?
Such issues swirled about in the wake of Lo's talk at the CFA Institute's presentation. The MIT professor's stated topic was exploring the prospects for replicating hedge fund returns, which is to say, producing returns systematically, over time, and without the need for a talented manager at the helm. In fact, some hedge fund strategies can be replicated, Lo advised, as his presentation suggested. What's more, those that can be systematically exploited are good candidates for tapping via quantitatively run index funds specializing in hedge fund betas.
Lo should know. In addition to studying such matters in academia, he's also delivering replicated hedge fund returns to institutional clients by way of the Cambridge, Mass.-based AlphaSimplex Group, a quantitative hedge fund firm he founded and where Lo serves as chief scientific officer.
In fact, a number of companies are pushing the envelope by offering the next generation of hedge fund indexing [see "In Quants We Trust," Wealth Manager, Feb. 2006, page 85] by way of computers. Quant-based hedge fund indexing is the wave of the future, Lo predicted in the following interview. That's good news for investors, as it implies that fees for alternative investing strategies will fall. But the revolution, as he sees it, is still in its infancy. As a result, traditional hedge fund managers shouldn't fear for their high fees...not yet.
What is the basic message from your talk at the CFA conference in February?
There are certain kinds of hedge fund-like returns that can be replicated relatively easily. The numbers I showed were an example. But I called the strategy of selling out-of-the-money S&P 500 put options the Capital Decimation Partners fund to emphasize the fact that there's no free lunch. In order to get the kind of attractive returns that the strategy generated, you had to be exposed to so-called tail risk, or the very rare but very extreme bad event that happens every few years. On the other hand, if that's the kind of risk you're willing to live with, you can generate attractive returns relatively easily.
Define "relatively easy."
The strategy that I outline involves selling S&P 500 puts that are 7 percent out-of-the-money. What could be simpler? You don't need to pay a hedge fund manager two-and-
twenty to do that. Anyone can do it.
Can every hedge fund strategy be easily replicated?
No. There are indeed certain strategies that can't be replicated in such a transparent way.
For the numbers presented at the CFA conference, we looked at hedge funds in the TASS database using four market-driven factors--S&P 500, Lehman Brothers Aggregate Bond Index, U.S. Dollar Index, and credit spreads. Those are four factors that anyone can trade in the open market. Using those four, we tried to see how close we could come to replicating various individual hedge funds in the TASS database, which has over 1,600 funds.
For each fund, we estimate a four-factor regression. Then we rank the funds on the R-squareds. The presumption is that the very low-R-squareds are the funds that aren't easily replicated in a linear regression strategy. Meanwhile, the high-R-squared funds are more likely to be replicated.
What are some of the hedge fund strategies that can be replicated?
Managed futures strategies, for instance, have a pretty high R-squared. But a high R-squared by itself isn't a sufficient statistic to determine if a strategy's replicable. So we also look at the hedge fund strategies and compare them to the linear replicating strategy's performance. In other words, we use R-squared as a smoking gun. Then we test it by constructing what we call a clone, by taking the linear coefficients and running a buy-and-hold strategy with the four market factors to replicate the actual fund. The ones that seem to be the most replicable are the directional strategies, like managed futures, global macro and long/short equity. These are strategies with a significant directional component, as opposed to, say, relative value or arbitrage strategies.
What strategies are more difficult, if not impossible to replicate?
Equity market-neutral, for example, is not so easy to replicate, because it's basically an active strategy using long and short positions.
What's the main lesson that springs from all this number crunching?
It suggests that if an investor's interested in certain types of strategies that are more directional in nature, they might want to consider a lower-cost replication strategy rather than paying a manager.
Are you suggesting that investors avoid traditional hedge fund managers specializing in directional strategies?
We're not arguing that managers don't add value, because with most of our examples there is additional value provided above and beyond the clone. So, it's not always the case that the clone can come close to the performance, although it can in some cases.
That said, depending on the strategy, investors may want to consider a lower-cost alternative. Hedge funds don't have a monopoly on generating interesting and different kinds of risk-reward profiles relative to traditional long-only investments.
Speaking of adding value, you also talked about the clones and the actual strategies by comparing Sharpe ratios at the conference. Review some of the highlights on that front.
We looked at the average Sharpe ratio of the actual funds versus the linear clones in each of the different categories (see Table 1). In convertible arbitrage, for example, the actual funds have a Sharpe ratio of about 2.75 or so, while the comparable linear clone has a Sharpe ratio of about half of that at under 1.5. That's an example where the clones aren't doing nearly as well as the actual strategies.
On the other hand, Sharpe ratios for dedicated short bias are similar for the actual strategies and the clone. That suggests that doing a linear clone for short bias isn't a bad idea.
Other cases where the clone's Sharpe ratio is comparable to the actual strategy are global macro, long-short equity hedge, and fund of funds.
Meanwhile, an example where the Sharpe ratio is much higher for the actual funds are event driven and fixed-income arbitrage. That's not so surprising.
Event driven, for instance, is a category where people are essentially investing in distressed securities and companies. These funds are buying assets at, say, 20 cents on the dollar because the companies are in bankruptcy. The fund then gets rid of management, hires new people, and generally changes the company. That's the kind of thing where you need the handholding of very experienced portfolio managers and dealmakers. You're not going to get that kind of exposure by replicating market factors like the S&P 500 or the Lehman Aggregate Bond Index.
Now, compare that with managed futures where you're basically getting exposure to financial and commodities futures and taking advantage of trends. That's an example where it looks like a linear clone might do better.
The bottom line is that there are certain strategies with particular risk characteristics that can be replicated.
Given your findings, what is your expectation for the hedge fund business?
Like any new industry, there's a fairly standard life cycle in the hedge fund business. Initially, you get a lot of excitement and a huge number of new entrants. Competition ends up driving away the weakest firms, and ultimately only the quality players survive. Eventually, consumers figure out what strategies are worth paying for.
That sounds like the early days of indexing in the 1970s, when passive funds were just beginning to nip at the heels of active managers.
That's a very good way of looking at it. Today, people understand that when you own an S&P 500 index fund, you'll get the S&P, because that's basically what's driving the performance. But we're only at the very beginning of that phase with hedge funds. For example, we have many hedge fund indices, none of which are investable. So we don't really yet understand how to use the insights garnered from the long-only index business. But people are learning more and more about what drives hedge fund returns.
In our study, we're talking about risk factors and what really generates alpha. As we develop a better understanding, we're going to develop index-based products and ETFs and so on. So I think you're absolutely right: We're right at the beginning of that kind of a revolution in the alternative investment business.
Overall, I think the mystique of hedge funds will start to wane.
What do you make of the various "investable" hedge fund indices already out there? Some critics say that these are really just funds of funds dressed up as indices.
That's right. In fact, from what I know, those investable hedge fund indices aren't nearly as liquid as you might like. They're basically putting money into other hedge funds. The problem is that those hedge funds are going to be capacity constrained. They already are.
So, a pension fund couldn't easily allocate 5 or 10 percent of assets to those indices and expect to get pretty close to the benchmark return with minimal tracking error. It would just swamp the liquidity.
But over time, as interest grows and people become savvier about these kinds of investments, true investable indices will become a reality. I don't believe it will happen in the way the investable indices are currently doing it. In contrast, what I'm talking about for a replicating strategy is investing in a transparent, exchange-traded instrument with relatively minimal liquidity constraints.
You're putting your research to practical use in the real world of money management. Tells us about that venture.
At the AlphaSimplex Group, where I'm chief scientific officer, we're working on a commercial product that will allow institutional investors to create clones of certain styles of hedge funds and mix them in a relatively low-cost way. But it's not going to be one-size- fits-all. Rather, it's a highly customized process, where we have to work with each institution and understand their risk mandates, their return objectives, their liquidity needs, and all the other various kinds of constraints particular to each client. Once you get through all of those things, they determine a fair bit of the constraints of what the weights can be across these different hedge fund factors.
It sounds like a fund-of-funds approach.
Yes, but it's a fund of funds without the fees on fees. In fact, it's more than that. First, we're not adding any managerial alpha on top of the portfolio construction process. That's an acknowledgement that we're not going to add the alpha that talented hedge fund managers can add. At the same time, we're also providing much more transparency about the strategies to the institution. In addition, we're providing much more flexibility in tailoring the risk exposures to the institution's particular needs. Overall, our approach provides investors a degree of transparency that hedge funds will never offer.
What are investors likely to give up with your approach?
It's not going to produce the outsized returns that really talented hedge fund mangers can generate. We acknowledge that, and we're not trying to do that. In fact, many institutions nowadays aren't looking for that. Instead, they want LIBOR plus three, or they have a liability mismatch problem and so they want to deal with it in a responsible way. In general, ours is a much cleaner, more responsible, more systematic process compared with giving your money to the mystical managers who may or may not follow your risk mandates.
Does the traditional hedge fund business take umbrage at what you're doing?
So far, we've had no adverse responses from the hedge fund world. Part of it is because we manage hedge funds as well, in addition to replicating strategies. Because we're engaged in hedge fund strategies, we're not going to be arguing that there's no value to active management. Clearly, there is. There are many examples of talented hedge fund managers.
But we're also trying to find a lower-cost alternative that serves a different market and a different purpose. There's always going to be a market for George Soros and Julian Robertson types. They don't have to worry about starving. We're simply trying to broaden the ideas behind alternative investments.