Will Hedge Funds Regress Towards Index-Like Products?

Abstract

Hedge funds have grown substantially in the past few years. According to estimates by Tremont Capital Management (2006), the industry's assets under management increased from just over $200b in 2000 to over $800b by the end of 2005. Along with the rapid inflow of capital, hedge fund performance has declined. According to HFR, the average fund of hedge funds returned 10.5% per annum during 1996-2000, but only 5.8% during 2001-5. This development is consistent with the prediction of Berk and Green (2004) that unchecked inflow of funds will ultimately erode performance due to diminishing returns to scale. There is a sense of deja vu among hedge fund investors that many hedge fund managers are beginning to resemble active managers in the mutual fund industry of the past - failing to deliver returns commensurate to the fees and expenses they imposed on investors. History tells us that over-priced active managers will be replaced by low-cost passive index-liked alternatives. Could the same process be taking place in the hedge fund industry? Against this background, it is not surprising that investors are demanding more cost efficient hedge fund products. But, is existing technology capable of support the creation of rule-based, low-cost, passive hedge funds? The term "alternative beta" refers to the returns achievable from low-cost replication of rule-based trading strategies that capture return characteristics common across hedge funds, while "alternative alpha" refers to the returns that are not easily replicated. The introduction of this terminology was partly motivated by the need to stress that the search for hedge fund alpha properly begins with the identification of beta exposure to systematic risk factors which can go beyond conventional asset-class factors. This in turn points to the need for new technology if alternative beta factors are to be replicated successfully - a new tool kit is needed.

Keywords: Hedge fund, rule-based trading strategy, synthetic hedge fund, passive index fund, trend follower, merger arbitrage strategy, alternative alpha, alternative beta