Despite escalating signs of recovery in hedge fund performance in recent months, investors are cheering a new product series that is designed to generate hedge-fund like returns while bypassing hefty fees and risks associated with hedge fund investing, says Rabbe Ekholm, founder of True Beta.
 
True Beta, a company that develops quantitative financial strategies for institutional clients, Tuesday launched an independent hedge fund replication service for investors. The products are in the form of a series of investable hedge fund indices that are designed to generate beta returns.

The True Beta Composite is an equally weighted index based on five prevalent hedge fund strategies, including equity hedge, event driven, macro, relative value arbitrage and emerging markets. These strategies represent 85% of all hedge fund trading, Ekholm says. The trading value is based on liquidity-screened futures and exchange traded funds as underlying investments.

The composite is a product that Ekholm says is in answer to investor demands for increased transparency, liquidity and better risk control and one that he expects will become the industry benchmark for hedge fund performance.

"Index investing will become a permanent and growing part of the new investment process [in the hedge fund space.] In the traditional investment process, index investing is an important part of that. That will happen in the hedge fund space and we're already seeing early signs of that happening," Ekholm says.

The lion's share of hedge fund returns are generated from beta performance, according to Ekholm. He encourages investors to select individual hedge fund managers who are alpha generators, but to also gain exposure to the True Beta Composite for beta returns (beta represents “anything that can be replicated in a systemic way,” while returns in excess of this are considered alpha, Ekholm says. )

Investors are still hunting absolute returns but can do without some of the inherent risks associated with hedge fund investing, such as lack of liquidity, “manager blow ups” and other risks that surfaced in 2008 and into 2009, according to Ekholm. “Investors ready to invest in hedge fund replication want to increase their allocation to hedge funds but they want conditions to be met. They are demanding better transparency and risk management and they are very ready to invest under those conditions,” he says.

True Beta's base-case fee structure is a 1.65% management fee and no performance fee. "That is about equivalent to what I have seen with other replication products," Ekholm says. Depending on their execution of the composite, investors also gain access to greater liquidity -- in some cases on a daily basis versus longer lock-up periods in most hedge funds.

The True Beta Composite Index correlates with the Hedge Fund Research (HFR) HFRI Index, a widely subscribed to barometer for hedge fund industry performance based on the activity of multiple thousands of hedge funds. Unlike the HFRI Index, however, the True Beta Composite Index is an independent investable product, Ekholm says.

The True Beta composite product has a correlation of 0.93 with the HFRI Index based on performance over the past five years, and a correlation of 0.91 in 2009 through August. Over the past five years, the barometer generated compound returns of 15.44% versus a decline of 1.71% in the HFRX Index, an investable HFR index that has a correlation of 0.90 to the HFRI Index. The HFRI Index is True Beta's target index.

In 2009 through August, the True Beta Composite Index generated compound returns of 7.89% versus returns of 7.24%in the HFRX Index during the same period. Ekholm noted on a conference call today that HFRX performance is not net of fees charged by HFR while the True Beta calculation is net of all fees. He does not make the same argument for the HFRI Index, since it is not an investable index. Instead, Ekholm says that although True Beta tends to under-perform the HFRI target index, factoring in the upward biases of broad hedge fund indices (approx. 3-4% per annum), True Beta delivers comparable performance.

“I don’t work directly with HFR on this. They have no relationship to this offering,” Ekholm said on the conference call. “I have chosen HFR on the basis I believe that based on their methodology they are well representative [of the hedge fund industry] although we could have used a number of other indices.”

The True Beta investable index launched today although the product has been in development for several years. “I have been getting encouraging feedback about the timeliness of the proposition and validating changes I see in the market place,” he says.

Prior to founding True Beta, Elkholm oversaw the content division at MSCI Barra, where he also developed hedge fund indices. MSCI Barra developed an investable hedge fund index alongside Societe Generale subsidiary Lyxor Asset Management at the time.