Goldman launches hedge fund clone
By Steve Johnson
Published: December 4 2006 11:43 | Last updated: December 4 2006 11:43
Goldman Sachs has become the first bank to launch a hedge fund replication tool that aims to deliver the returns of the hedge fund universe at a fraction of the cost.
Goldman’s Absolute Re-turn Tracker Index, or Art, is in the vanguard of an expected flood of hedge fund “cloning” platforms that could put pressure on many run-of-the-mill hedge funds to justify their high fee structures, typically a 2 per cent annual fee and a 20 per cent performance fee.
Academics in Europe and the US claim to be on the verge of commercialising their own cloning strategies, a trend that promises to be as disruptive for the $1,300bn (€980bn, £660bn) hedge fund industry as the arrival of passive index trackers was for long-only mutual funds a generation ago.
All the strategies rely on a belief that much of the performance delivered by hedge funds is beta, ie is based on the movements of underlying markets, rather than alpha, excess return generated by a skilled manager. If so, generic hedge fund performance may be replicable at a fraction of the cost.
“Art cuts out a significant amount of management fees. Total expected fees in some funds of hedge funds can range from 4 to 7 per cent per annum, which probably represents up to 25 to 50 per cent of gross return. That is a large amount to pay, depending, of course, on what you are getting,” said Edgar Senior, executive director in Goldman’s fund derivatives structuring team.
“If broad-based passive exposure is what investors are looking for, perhaps they can get that more cheaply by replicating the broad underlying investments of hedge funds. If you can get that right with a reasonable degree of accuracy, you can then replicate the aggregate impact of their trading strategies, without management fees.”
Goldman has spent two years developing the complex algorithm that underpins Art. The performance characteristics of thousands of hedge funds are fed into Art on a monthly basis, and the system decomposes these data to determine the aggregate position of the hedge fund universe, eg the degree to which funds are long or short the S&P 500, small-cap stocks or commodities.
Goldman will then use a variety of real assets and options contracts to replicate this positioning for the following month, meaning Art is essentially free of capacity constraints. It believes the one-month time lag has little effect on performance.
“The algorithm tries to answer the question: what is current hedge fund asset allocation,” said Klaus Toft, who led the development of Art, although he stressed it is designed around Goldman’s knowledge of hedge funds rather than being purely mechanical.
The US bank believes Art will produce better risk-adjusted returns than existing investable hedge fund indices and funds of hedge funds for two reasons. First charges will be much lower, with an annual index fee of 0.65 per cent and a monthly rebalancing fee of 3 basis points resulting in a total annual cost of 1.01 per cent.
Art also avoids the problem of negative selection risk, whereby the best hedge managers are often closed to new business and are therefore not included in investable indices or funds of funds.
This appears to be borne out by Goldman’s back testing. Art’s simulated track record shows that, had it existed prior to now, it would have generated net returns of 11-12 per cent per annum since 2003, which Goldman says is probably 4-6 per cent higher than many comparable funds of hedge funds over the same period.
Art’s performance would have been comparable to the non-investable Credit Suisse/Tremont index, which does not suffer from negative selection bias but, by definition, cannot be invested in.
Art also promises to be more transparent than existing vehicles – Goldman will publish its monthly asset allocation – and more liquid, with trading permitted on a daily basis.
Copyright The Financial Times Limited 2006
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