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London Research Suggests Hedgies Are Too Expensive

by Carla Johnson, Investors Offshore, London

30 November 2006

New research from Cass Business School in London shows investors who want higher returns from hedge fund investments that they should sack their overpaid fund managers and replicate the funds themselves using mechanical futures trading strategies (or “synthetic funds” for short). In most cases this will significantly boost returns.

In a large-scale test involving almost 2,500 (funds of) hedge funds, Harry M. Kat, Professor of Risk Management at Cass, and leading international hedge fund expert, shows that over the past 15 years, synthetic funds would have outperformed real (funds of) hedge funds 82% of the time.

Traditionally, hedge fund managers have charged investors extremely high fees, generally an annual management fee of 2% plus an incentive fee equal to 20% of profits. Funds of funds add a second layer of fees of on average 1% plus 10% of profits. “In the early days, the high fees came on the back of 15-20% returns,” Professor Kat says. “Things are very different now; hedge fund returns are routinely around 6 – 7%, basically the same as a glorified savings account. If fund managers are taken out of the picture, however, returns can be boosted by 2 or 3%.”

Professor Kat’s research shows that, using purely mechanical futures trading strategies, it is possible to design synthetic funds which generate returns with the same risk characteristics as (funds of) hedge funds. Thanks to their mechanical nature, synthetic funds can be run without involving an expensive manager. Although this means that investors may miss out on possible superior trading skills, it also means they avoid the excessive management fees that come with it.

“The significantly better returns gained by investing in synthetic funds confirm that efficient risk management and cost control tend to be much more certain routes to superior performance than trying to beat the market while paying excessive management and incentive fees.”

Professor Kat argues that since they only trade in the most liquid futures markets, synthetic funds also avoid all the other typical drawbacks of alternative investments, such as the need for extensive due diligence, liquidity, capacity, transparency and style drift problems, as well as possible regulatory problems. Together with their low management costs, this makes synthetic funds an extremely attractive alternative to direct investment in hedge funds.

Professor Kat and his colleague Helder Palaro have designed a ‘FundCreator’ system which tells investors how many futures contracts they need to buy or sell to create returns with the same statistical properties, such as volatility and degree of correlation with stocks and bonds, as a given hedge fund. While ultimately returns are in the hands of the investor, realistic backtests indicate that in some cases they can make a very respectable 10% average return per annum.

Professor Kat predicts the alternative investment market will rapidly move away from active management over the next 10 years. “20 years ago active fund management in the traditional investment market was the status quo until someone came up with a system for managing funds through an index, doing away with the need for an active manager. Index fund management now accounts for 40% of the traditional investment industry and I predict we will see a similar market share for synthetic funds 10 years from now.”

Cass Business School, City University, undertakes research of national and international significance and supports almost 100 PhD students. Cass has the largest Finance Faculty and the largest Actuarial Science & Statistics Faculty in Europe. Its finance research is ranked 2nd in Europe and 4th in the World outside the US by Financial Management Magazine and our insurance and risk research is ranked 2nd in the world by the Journal of Risk and Insurance.

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