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Hedge Fund Replication Strategies - The Cheaper Option

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A growing number of institutional investors are considering a move into sophisticated, rules-based trading strategies that meet or beat hedge fund index returns - at a much lower cost.

Sources predict that interest in hedge fund replication - still nascent in the global institutional investor universe - is likely to account for 5% to 25% of total institutional investment in hedge funds over the next 10 years.

If the predication proves to be true, that would put between $13 billion at the low end and $63 billion at the high end up for grabs by hedge fund replicators in the U.S. alone (in current dollars).

That's good news for hedge fund replicators and even better news for institutional investors, who will be able to achieve similar returns to a multi strategy hedge fund, typically paying the manager a 1% to 2% management fee or a 15% performance fee.

Considering that hedge funds typically charge both a 1% to 2% management fee and a 15% to 20% performance fee, consultants said the savings from a replication strategy end up being an alternative alpha source for an investor's hedge fund portfolio.

Not everyone will be happy about hedge fund replication consuming an ever larger percentage of institutional hedge fund portfolios. "Hedge fund managers will fight this trend because it likely will be a game-changer, especially for those managers who claim to be producing alpha and aren't really doing so," said Deepak B. Gurnani, managing director, chief investment officer and head of hedge funds at alternative investment manager Investcorp International Inc., New York.

Investcorp manages $4.6 billion in hedge funds of funds and an emerging manager seeding program but does not offer a replication strategy.

Right now, demand is exceeding supply for hedge fund replication strategies robust enough to attract institutional investors.

"There is tremendous interest in replication because of cost reduction and as a way to separate hedge fund alpha from hedge fund beta," said Daniel Celeghin, partner, Casey, Quirk & Associates LLC, Darien, Conn., in an e-mail.

But CQA, a consultant to money managers, has not tried to forecast how much the hedge fund replication industry will grow because its researchers "see the big constraint being supply. There simply aren't enough high-quality offerings," Mr. Celeghin said.

In fact, sources pointed to AQR Capital Management LLC, Greenwich, Conn., as the only money manager gathering significant institutional inflows into its hedge fund beta strategy Dynamic Economically Intuitive Liquid Transparency Alternative better known as DELTA

Four years after its launch, DELTA now has $4.5 billion under management, about 95% of which is from 100 institutional investors, including the $108.9 billion Teacher Retirement System of Texas; the $7.7 billion Missouri State Employees' Retirement System; and the Oregon Investment Council, which runs the $57.9 billion Oregon Public Employees Retirement Fund.

The field of hedge fund replicators was much larger prior to the 2008 financial crash, when factor-based approaches were successfully capturing equity beta and attracted a few early movers among European pension funds.

But these statistical replication strategies, which used regression analysis to look backward for the factors to determine hedge fund strategy exposures, lost their appeal after the crash.

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