Clones Should Have Hedge Funds Running Scared

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A new research paper sheds positive light on so-called hedge fund clones — financial products designed to mimick the performance and volatility of major funds.

FT Alphaville: It’s hardly surprising, perhaps, that synthetic hedge fund clones are putting an increasing amount of pressure on the “real” hedge fund industry and on the fees it charges. But a recent paper on the nascent, but already highly-lucrative, industry of hedge fund replication — entitled “How do hedge fund clones manage the real world?” — puts it all in stark relief.

In their analysis, posted on the CAIA Association website, authors Nils Tuchschmid, Erik Wallerstein and Sassan Zaker of Julius Baer Asset Management suggest the clones are broadly succeeding in replicating the investment returns of real hedge funds. At the same time, however, some clones have exhibited too much correlation with equity markets and also have raised fears among some investors about the increasing complexity of replication models, the researchers warned.

These clones — which are being marketed heavily by the likes of Goldman Sachs, Barclays, and others — may pose the best shot at exploding the standard 2 and 20 hedge fund fee model.

But it’s embarrassing that these hedge funds are so easily cloned. It speaks to the relative lack of strategic depth being employed that a long-short fund is so easily replicated by outsiders.

And thust he clones represent what looks like a real (and rare) financial innovation. Like, say, the emergence of the ETF, hedge fund clones have the potential to reduce profit margins in finance, rather than expand them, as many of the so-called financial innovations of the past did.

That being said, there’s no promise that these won’t, at some point, blow up and violently deviate from the performance of the hedge funds being replicated. As dumber money flows to the cheap stuff, we can, if nothing else, expect the unexpected.

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