Merrill Lynch: The Emergence of Passive Hedge Funds

Business Wire, Oct 18, 2006

NEW YORK -- Rules-based passive hedge fund strategies could provide an increasingly attractive alternative to active hedge fund management as the industry continues to mature according to Merrill Lynch (MER) analysts. They expect strategies will increasingly emerge that aim to replicate hedge fund performance - either by using liquid assets like stocks or by mechanically executing hedge fund strategies - enabling investors to achieve similar returns to hedge funds with lower fees. Investors in such instruments may also benefit from greater liquidity and transparency.

No asset class has seen such tremendous growth as hedge funds have seen over the past 15 years and few financial instruments command such high fees. "Passive strategies, some of which are increasingly the focus of academic research, aim to provide returns similar to hedge funds without the need for active management. Because of their lower cost, we believe these vehicles have the potential to outperform actively-managed hedge fund investments on an after-fee basis,"explains Benjamin Bowler, co-head of Global Equity-Linked Research at Merrill Lynch.

Greater competition should fuel interest in passive alternatives

The growth in both the number and size of hedge funds over the last 15 years has been breathtaking. Since 1990, hedge fund assets have grown to an estimated US$1.2 trillion, while the number of hedge funds has risen to around 7,000 globally according to Hedge Fund Research. Investors seeking absolute returns and a source of diversification for their core portfolio continue to invest money into hedge funds at a record pace with $66bn being added in the first half of 2006.

As the market has matured, institutional investors rather than individuals have become the dominant players. This has resulted in a steady concentration of assets in the largest hedge funds, with the largest 100 funds now managing 65% of hedge fund assets. Competition for manager talent and available returns is rising as firms employ similar strategies, and it is becoming more difficult for the smallest players to remain competitive.

"Competitive pressures are increasing the value of high quality active management that can generate superior returns. However, with thousands of active managers competing with each other, it may be increasingly difficult for investors to justify paying hedge fund fees for the performance of the average active manager if passive alternatives are available," said Heiko Ebens, head of U.S. Equity Derivatives Research at Merrill Lynch. "This is entirely analogous to developments we have witnessed within traditional asset classes, where passive management has become an increasingly popular alternative to active management as the industry has matured."

Hedge fund replication using liquid instruments

One method for generating hedge fund returns highlighted by Merrill Lynch analysts involves replicating hedge fund performance by investing in a dynamic portfolio of liquid assets such as equities, bonds, currencies and commodities that statistically track hedge fund returns. An increasing amount of academic research has been focused in this area. Key benefits to this approach include significantly enhanced liquidity and transparency versus a traditional hedge fund investment as well as the elimination of single-manager risk, both of which are of increasing concern to investors.

Another benefit of this style of passive replication is the potential to create liquid and tradable hedge fund index products that allow investors not only to go long a hedge-fund tracking instrument but also to go short. For example, an investor may want to isolate the outperformance of an active hedge fund manager or to hedge against a downturn in a particular investment strategy by shorting a tradable hedge fund index - similar to the way traditional asset managers use liquid benchmark tracking instruments today.

These replicating portfolios are not without risk as they aim to forecast future hedge fund behavior with past returns. If hedge funds change their investment styles too quickly, replicating portfolios may lag behind. There is also debate about which tradable factors to include in the replicating portfolios and whether these factors need to change over time.

Mechanical replication of hedge fund strategies

Another option for replicating hedge fund returns is to mechanically invest in strategies similar to those hedge funds execute, using a systematic rules-based methodology instead of active management. This approach can also reduce fees and improve transparency and liquidity. A good example of this would be merger arbitrage. Active merger arbitrage managers monitor ongoing mergers, buying the stock of companies they believe will be successfully taken over and avoiding those that represent too high a risk. By applying a rules-based approach, the lower costs required to follow these rules may be able to more than offset the benefits some active managers add. A wide range of other common hedge fund strategies may also be employed such as volatility arbitrage and convertible arbitrage. Because this style of investing does not aim to track hedge fund returns but rather employ similar strategies, a distinct benefit is the potential for some styles to even outperform typical hedge fund benchmarks. The fact they can be executed at lower cost is an additional benefit.