Why Clone the Uncloneable? (In Defense of Talented Hedge Fund Managers)

Cloning hedge fund indexes with liquid portfolios is hot these days. Major players, including Goldman Sachs, Morgan Stanley, Barclays, Societe Generale, and BNP Paribas, now offer hedge fund index clones. But guess what? These clones underperform the hedge fund indexes they were designed to replicate! The clone sponsors readily admit that, pointing to many technical reasons as to why that is the case (and a recent study by Ben Dor, Jagannathan, Meier, and Xu does a great job in explaining these). However, the most fundamental question is not usually mentioned at all – I mean, why is cloning expected to work in the first place?

Hedge fund indexes are comprised of individual hedge funds, run by hedge fund managers. Broadly speaking, hedge fund managers can earn their returns by either constantly producing new and ever ingenious investment ideas (this requires true talent), or by riding some obscure risk factor with the help of a “secret formula” that doesn’t really change over time. An example of the latter investment strategy could be writing out-of-the-money put options on the S&P 500 index. Can we clone such a strategy? You bet!

On the other hand, what about the Scion Capital’s strategy, which is based on a tireless quest for value investments by its manager, Michael Burry? He endured the painful task of reading through all the details in prospectuses of subprime-mortgage-backed securities prior to making a bet against them back in 2005. How are we going to clone that? We just can’t – true talent is “non-cloneable”!

The bottom line is that there is a fundamental difference between “cloneable” and “non-cloneable” hedge funds! “Non-cloneable” hedge funds are run by talented managers, while “cloneable” funds are run by static formulas (and this is one of the main points of my research paper with Jun Duanmu and Eddy Li). All broad hedge fund indexes combine both “cloneable” and “non-cloneable” hedge funds, and that is why any effort to clone a broad hedge fund index is fundamentally flawed in the first place!

The right approach would be to construct an index of only “cloneable” funds, and see whether it delivers desirable risk-and-return properties. A liquid clone of such an index would hit the mark spot on!

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