AlphaWeek’s Greg Winterton discussed the ever-growing hedge fund replication industry in a Q&A with Stephen Scott, Partner, BRI Partners, a provider of investable index products for institutional investors.
GW: Stephen, thanks for taking the time today. Hedge fund replication is all the rage these days, given that they provide better liquidity at a lower cost than traditional hedge fund structures; the BRI Indexes are one example of this type of product available to institutional investors. What feedback are you seeing from these investors regarding these products?
SS: Thank you. Investors do recognize the structural benefits of hedge fund indexes, including greater transparency, liquidity and lower cost. That said, it is the performance and due diligence utility of true benchmark indexes that is driving investor interest. These next generation indexes are designed to deliver the risk and return profile of hedge fund strategies in the same way as active funds.
GW: The reasons that hedge fund returns have not outperformed the market in recent years include a low interest rate environment and low volatility. The Fed and the Bank of England increased rates last year, and many commentators expect volatility to increase in 2018. Won’t that help the traditional alpha generators to return to form?
SS: The macro environment has been challenging for active managers and the strong bull market has made it very challenging for most hedged strategies to keep pace. If rates move higher, that should help strategies that are priced off of the risk free rate, like most arbitrage strategies. Increased volatility should provide more tactical managers an opportunity to produce alpha through exposure management.
GW: Do you see asset flows continuing to move to passively managed investment products in 2018? If so, aren’t these investors lining themselves up for a fall when we next experience a bear market?
SS: Yes, we believe investors will continue to seek the efficiency of passive products. Technology is making it possible for indexes to capture returns above and beyond market beta. Yesterday’s alpha is now today’s beta. Obviously, bear markets are challenging for any type of long exposure, whether active or passive.
GW: Despite the pushback on hedge fund fees, BRI Partners claimed in a recent blog post that fees might, in some instances, rise. Why is that?
SS: As indexes deliver more and more of the beta identified in academia, there is less true alpha available. As long as investors demand alpha, the active managers that can consistently deliver it will command a premium fee.
GW: Tell us about how the BRI Indexes are constructed; what makes them different from other hedge fund replication products?
SS: Our indexes are a bit unique in that they are built from the bottom up. Unlike aggregation or replication indexes which attempt to mimic hedge fund performance synthetically, BRI indexes are designed to deliver the same compensated factors that active managers do. Each of our indexes are investable and comprised of the same underlying securities as the active strategies they benchmark.
GW: Finally, Stephen, do you see the increase in interest in alternative beta products from the allocator community to be a fundamental shift in how investors are looking to construct their portfolios or will they simply move money around various different products depending on the prevailing macroeconomic environment?
SS: Investors can now allocate to alternatives in the same way that they allocate to traditional investments. This bar bell approach combines both active alpha and passive beta allocations. Over all fees are reduced and investors have greater liquidity and flexibility to adjust exposures as the economic environment changes.