State Street Global Advisors (SSgA) will launch a global ‘synthetic’ hedge fund which aims to better the return of the average hedge fund of funds after fees.

The synthetic fund will invest not in the hedge FoFs themselves, nor the underlying hedge funds, but rather in a range of investments which closely matches the characteristics of their returns when taken as a group. Merrill Lynch and Goldman Sachs, the US-based investment banks, have launched similar products in the past 12 months, while others, such as Morgan Stanley, are providing ‘transparent hedge fund platforms’ (see separate report). The fund should comfortably beat the average return of hedge FoFs, as expressed by the main indices. Hedge FoFs invariably also fail to match the composite index return of underlying funds, not only because of fees but also a range of other reasons including investability. In Australia yesterday for SSgA’s annual client conferences in Sydney and Melbourne, Paul Brakke, head of the firm’s global structured products group, said that hedge fund indexes were suspect for several reasons: survivor bias, lack of investability, inclusion vagaries and fees. The SSgA fund, which is yet to be seeded, will have a standard fee of 50bps. Many hedge FoFs have a management fee of 100bps and performance kicker of 10 per cent, on top of the management and performance fees of their underlying managers. SSgA research by academics William Fung and David Hsieh has shown that hedge fund returns, as a group, can be explained with traditional style analysis. They developed an eight-factor model including four risk premia (equity risk, term premium, credit premium and small-cap premium), three ‘lookback’ option straddles (which capture the tail of returns when markets are very good or very bad) and emerging markets. The model is shown to capture 85 per cent of the return variance of the hedge FoF index. While the fund will be recalibrated monthly, its average investment weights for the past four years would have been more than 50 per cent in cash and 20 per cent in emerging markets. “Hedge funds have a lot of beta,” Brakke said. “Why should investors pay 2 and 20 for risk exposures they already have?” He said the synthetic hedge fund was a better asset class benchmark than the main indices and also presented an efficient way to gain exposure which was free of manager-specific risk, easy to explain and replicate, transparent, liquid and low cost.

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