Research: Synthetic Funds Outperform Fund Of Hedge Funds

Nov 28 2006 | 3:14pm ET

Investors who want higher returns from hedge fund investments should fire their overpaid fund managers and replicate the funds themselves using mechanical futures trading strategies, according to new research from Cass Business School.

In a test involving almost 2,500 funds of hedge funds, Harry Kat, professor of risk management at the London-based school, shows that over the past 15 years, synthetic funds would have outperformed real funds of hedge funds 82% of the time.

“In the early days, the high fees came on the back of 15-20% returns,” Kat says. “Things are very different now; hedge fund returns are routinely around 6 – 7%, basically the same as a glorified savings account. If fund managers are taken out of the picture, however, returns can be boosted by 2 or 3%.”

Kat predicts the alternative investment market will rapidly move away from active management over the next ten years. “Twenty years ago active fund management in the traditional investment market was the status quo until someone came up with a system for managing funds through an index, doing away with the need for an active manager,” he says. “Index fund management now accounts for 40% of the traditional investment industry and I predict we will see a similar market share for synthetic funds ten years from now.”

Kat’s research shows that, using purely mechanical futures trading strategies, it is possible to design synthetic funds which generate returns with the same risk characteristics as funds of hedge funds.

“The significantly better returns gained by investing in synthetic funds confirm that efficient risk management and cost control tend to be much more certain routes to superior performance than trying to beat the market while paying excessive management and incentive fees.”

Kat argues that since synthetic funds only trade in the most liquid futures markets, they also avoid all the other typical drawbacks of alternative investments, such as the need for extensive due diligence, liquidity, capacity, transparency and style drift problems, as well as possible regulatory problems.

Kat and his colleague, Helder Palaro, have designed a ‘FundCreator’ system which tells investors how many futures contracts they need to buy or sell to create returns with the same statistical properties, such as volatility and degree of correlation with stocks and bonds, as a given hedge fund. While returns are in the hands of the investor, realistic back tests indicate that in some cases they can make a very respectable 10% average return per annum.

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