Hedge Fund Wannabes

Replicators mimic the high-risk portfolios at a fraction of the costbut results are mixed so far

What newfangled investment is getting the most buzz on Wall Street? These days it's hedge fund replicators, which promise to deliver the outsize returns of hedge funds at a fraction of the cost. The early results are mixed, though. So it's not clear whether these offerings will be as good as the real thing or just cheap knockoffs.

The investment process behind these portfolios is more science than art. Using mathematical models that crunch historical trading data, managers buy and sell options, puts, and other derivatives to mimic the moves of successful hedge fund strategies. They're not trying to match the returns of a specific hedge fund. Rather, they're more like index funds, which aim to track the performance of a specific benchmark. And replicators may prove a good substitute for hedge funds.


The hedge fund industry shouldn't feel threatened just yet. There are only a handful of offerings for big institutional investors and just one for individuals: Rydex Absolute Return Strategies Fund, a two-year-old mutual fund that blends five different hedge fund strategies.

So far replicators haven't posted the same gains of their bigger brethren. The average hedge fund is up 10.2% through Nov. 30, according to Hedge Fund Research. The typical fund of funds, which invests across several portfolios, is up about 9.68%. Over that period, the Merrill Lynch (MER) Factor Index and HedgeIQ, two replicators available to large institutional investors, returned 7.25% and 9.16%, respectively. Rydex Absolute Return has gained 3%. IndexIQ, manager of HedgeIQ, notes that its clone beat the CS/Tremont hedge fund "investable" index, which only includes funds available to new investors, by roughly two percentage points.

Replicators, most of which have been around for a year or less, may show their value over time given their advantages vs. traditional hedge funds. For one, most have a flat expense rate of just 1%. (Rydex has a 1.45% tariff.) The typical hedge fund, by contrast, charges a 2% management fee and keeps 20% of profits. The popular funds of funds tack on an extra 1% management fee and take an additional 10% cut of the profits.

Investors in replicators also can unload shares at any time, and the Rydex fund has a $2,500 minimum initial investment. Hedge funds lock up a client's money for at least a year and require $1 million or more up front. "With these kind of strategies you are not going to get hurt too much," says Patrick DiNuzzo, president of DiNuzzo Investment Advisors, who has started putting clients into replicators.

Despite replicators' uneven performance, Wall Street is ramping up its offerings. Goldman Sachs (GS) recently rolled out a replicator for institutions, while JPMorgan Chase (JPM), Morgan Stanley (MS), and Credit Suisse (CS) have announced plans to do so. Both Merrill and IndexIQ intend to launch mutual funds in this flavor—broadening options for retail investors. Says Edward M. Egilinsky, managing director at Rydex Investments: "We can give you the majority of the risk and reward of a hedge fund for a much lower fee."

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