This week I heard yet another presentation from a large financial institution regarding their hedge fund replication product—described as “average hedge fund returns–without the lock-ups and the costs of a typical hedge fund”. Cringe—that statement is just wrong on so many levels. For now, let’s ignore the faux pas of word choices/intent from business and legal standpoints, and leap into the practical considerations–
To lay the framework, a well-formulated hedge fund strategy belongs in most sophisticated investment portfolios. Why is this? Some of the most talented investors in the world only manage money in the hedge fund format—so investing in their hedge fund is the only way to access their investment talent. Also the hedge fund format is less constrained than other investing formats which allows talented asset managers more leeway in implementing their investment themes.
Replication strategies are less than perfect–yet even if we ignore the shortfalls inherent in replication implementation, smart investors still know not to accept “average” in anything having to do with hedge funds. There is just too much dispersion of returns, both within managers and within sectors, to ever accept “average”. First, it is not uncommon for there to be a full 5 percent annual difference of returns between the 25th percentile and 75th percentile of managers within a hedge fund sector—and some years the difference may exceed ten percent. Second, on top of the wide dispersion of returns between hedge fund managers within sectors, there is also huge dispersion of returns among sectors of hedge fund returns. See the chart below from J.P.Morgan Asset Management based upon HFRI data. For the ten years ending December 2018, the top-performing hedge fund sector of Global Equities had an average annual return of 10.0 percent vs. an average annual return for the bottom sector of Quant of only 0.2 percent.
Never go for average with hedge funds—go for the best. Stay away from replication strategies, or any other hedge fund strategy which argues “average” returns.
Carrie McCabe – Read more on forbes.com