Hedge Funds for the Masses Missed the Mark?

A recent article in Morningstar highlights the debate surrounding what it describes as the “general-public version” of hedge fund—replication funds.

Ten years ago, the article explained, hedge funds were “the glamorous investment” because they were accessible only to the wealthy. Enter replication funds–developed in 2007 by two MIT professors who recreated hedge fund strategies using data from 1,600 funds over the previous 20 years. These “clones” made the hedge fund investing concept accessible to the average investor.

In their subsequent report, the article said, the professors were “admirably modest” in their assessment of performance results: “While the performance of linear clones is often inferior to their hedge fund counterparts, they perform well enough to warrant serious consideration as a passive, transparent, scalable, and lower-cost alternative to hedge funds.” The industry, however, was “less bashful” in how these products were marketed—”product marketers oversold the concept, thereby creating unrealistic expectations that could not be met.”

The article offers the following chart to illustrate the 10-year performance of three such replication funds:

“The graph is straightforward to interpret,” the article explains, noting that “the replication funds have trailed the indexes by about 2 percentage points per year,” performance that it says has been widely regarded as a failure. But these funds met their original performance expectations, the article points out–it’s the product marketers that overpromised. “Add to that mix the disappointing overall performance of hedge funds,” the article concluded,”and the result was a market failure.”