Low-Cost Hedge Fund Replication May Threaten Securities Lawyers

It’s a brave new world, and securities lawyers should be considering how their role in that world will work.

lawyer sign contract signature lawThe hedge fund industry has been perhaps the only bright spot in the increasingly grim world of active management over the last decade. While passive investment funds like many index ETFs (exchange-traded funds) have seen huge asset inflows, investors have been fleeing actively managed funds in droves. Hedge funds have been the lone area that investors are willing to pay for active investment advice in. A new financial product threatens to change that reality and in the process undermine a cornerstone of many securities law firms.

Hedge funds rely on using exposure to a variety of esoteric asset classes to generate returns with limited risk. While public perception is that hedge funds have tremendously high investment returns, the reality is that most do not. Firms like Renaissance Technologies have had returns that are much higher than the broader market – in RenTech’s case, returns are 35% annually for 24 years, according to data from hedge fund website Octafinance – but the average hedge fund return is actually ~30 basis points lower than that of the broader market, according to researchers. While the broader market returns about 11.2% over the last 30 years, hedge fund returns have been about 10.9%.

Instead hedge funds sell themselves on lower levels of risk, and limited correlation with the overall market. The evidence around this is mixed, and I have far more to say about hedge fund selection than I can write in one column. Still, the broader point is that hedge funds are as much an expensive risk mitigation tool as they are a return enhancement tool. Expensive is the operative word in the sentence, though.

Traditional hedge funds charge according to the two and twenty model. Those costs are justified because hedge funds provide access to investment strategies that are not available to investors on their own. But what if they were?

There are now a variety of new ETFs and mutual funds being launched that aim to replicate the returns of hedge funds at a fraction of the cost. These new replicated hedge funds take varying levels of exposure to eight different asset classes that have been shown to be closely related to hedge fund returns. The graphic below shows how the clone funds perform (click to enlarge):

HFClone

The results show that in some cases hedge funds outperform their clones, but in other cases, the clones outperform hedge funds. Overall then, hedge fund clones could be a powerful alternative for fee-conscious investors, especially in some sectors of the hedge fund world.

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New ETFs in the hedge fund replication space are being released by prominent asset managers like Goldman Sachs. Make no mistake, the product is real and significant. For securities lawyers, it’s time to prepare for a future where hedge funds may not be the staple of investment alternatives that they are today.

That means that securities lawyers should be helping hedge fund clients to articulate their advantages over clone funds – this could include quantitative algorithms that clone funds cannot replicate, or it could include access to investment areas that are not available to clones such as litigation funding and cat bonds. Regardless, it’s a brave new world, and securities lawyers should be considering how their role in that world will work.


Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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