If the trend is towards core-satellite hedge fund portfolios, what does that mean for resource budgeting? It is tempting to see this as a passive-active portfolio - why would an investor not wish to maximise her budget for the active part and minimise her budget for idiosyncratic risk, illiquidity risk and, of course, costs, in the passive part? This is the argument behind ‘hedge fund beta’ - investable indices, ETFs, super-diversified funds of funds and quantitative, hedge fund replicators.

“The most popular way to use replication seems to be within a core-satellite portfolio, with the replication providing a liquid, transparent, cost-effective core,” says Mike Arone, EMEA head of product engineering at SSGA, which provides hedge fund replicators. So does AQR Capital Management, whose head of portfolio solutions, Adam Berger, says: “If you can find true alpha, maybe you should pay more than 2-and-20 for it? If you get the systematic elements much cheaper then the weighted average fee burden will come down and free up some budget for that valuable alpha.” AQR’s DELTA Fund has proven popular with large institutional investors, most of which already have single-manager allocations, according to principal Ronen Israel: “They’ve sat across the table from enough funds to recognise common risk factors driving their returns.”

At Frontier Capital Management, the Global Hedge strategy aims to combine the two ideas of fund indexation and replication. Fifty percent of the fund is in four different replicators (Frontier monitors 21 in total), all offering daily liquidity. The rest is a fund of funds that matches the shape of the industry as a whole. Each strategy is divided into a three-by-three matrix of length of track record, size of fund and geographic exposure. Each of the nine resulting cells is populated, on an equal-weighted basis, with managers, and each cell is sized according to its share of the overall industry. Large developed-market long/short equity with long track records, for example, contains 41 managers. The sheer number of underlying managers cuts idiosyncratic risk as well as illiquidity risk (Global Hedge will offer liquidity twice a month with five days’ notice).

“Long/short equity lends itself to replication, so we could ultimately say that we are not going to use managers at all, whereas other places, like distressed, obviously needs managers,” says CEO Mike Azlen “That will probably be the way the product evolves, to get the optimal mix and improve liquidity and save even more on fees.”

There are a number of objections to this approach. It is difficult to explain how one gets exposure to an important systematic hedge fund risk - the illiquidity premium - with such liquid positions.

“In the long run our replicating strategy is likely to underperform the HFRI, while we expect to outperform the investable HFRX index,” says Willem van Dommelen, head of investments in ING Investment Management’s systematic beta division, of its Alternative Beta Fund. “This could partially be explained by the fact that you will not get the illiquidity risk premium.”

The odd thing is that one might expect much greater long-term underperformance from this stripping out of illiquidity. Why is that not the case? The suspicion must be that other risks are taken to compensate. That is another objection - replication looks like curve-fitting, which is both backward-looking and, potentially, divorced from the fundamental drivers of hedge fund returns.

“If you look at merger arbitrage’s distribution of returns it looks like a short-vol, short-put option strategy,” notes AQR’s Israel. “A replicator might conclude that all you need is an option payoff, but what you find is that the actual returns are greater if you run the strategy bottom-up than what you get if you simply run the returns distribution. How come? There is something embedded in the returns that you can’t capture simply by replicating a payoff.”

Van Dommelen does not deny this. Replication of aggregate hedge fund performance works better than individual strategy replication, he says. “All these hedge fund styles bring different alphas which, in turn, means that at the aggregate level you will get a more stable return that is easier to replicate.” But, as he concedes, the flip-side of this is that “it’s difficult to say precisely which exposures you capture and which you don’t”.

But even if you genuinely got the aggregate performance of the hedge fund industry, why would you want it? Some systematic risks in hedge funds are ‘complex’ or ‘exotic’ - but a big share is anything but. “The first generation replication strategies were simply not attractive,” says Simon Fox, senior hedge fund researcher with Mercer. “They were picking up a lot of equity risk, which is clearly not a great diversifier for our clients.”

But as his comment suggests, the world of replication is changing. Mike Powell of the absolute return strategies team at the UK’s Universities Superannuation Scheme describes the product from State Street that it uses as being “less about trying to mimic the overall industry and more about creating a separate absolute return product that minimises left-tail risk”. As Arone explains: “Investors come to replication expecting some kind of tracking of broad indices - but why would we want to do that? Helping them to see it as providing a systematic return stream that has low correlation with their traditional portfolios is an important part of what we do.”

Like SSGA, AQR does not see its DELTA Fund as a replicator, as such. Instead of curve-fitting to a dataset of historical returns, it starts by identifying the core economic themes in successful hedge fund strategies, before putting those ‘classic trades’ on in a systematic way. Take global macro currency trading, for example - it’s a heterogeneous opportunity set, but most managers will have a favourite carry trade anchoring their portfolio. “We would then take a more diversified, global approach to that theme,” says Israel. “Our portfolio may well look different from any individual manager’s portfolio at any one point in time, but the behaviour over time will begin to look more and more alike. You see the same thing happening in funds of funds, as the idiosyncratic risks get diversified away. We’ve just tried to systematise that and make it a better value proposition.”

“Many clients consider that, over time, DELTA will become part of their core hedge fund portfolio,” as Berger puts it. “They see it as a way to get diversified, transparent and relatively liquid access to a core set of strategies, before adding satellites around it where they can find managers who add something really unique.”

That is the argument against the most common objection to hedge fund beta - that hedge funds should be about alpha. Sensible use of hedge fund beta is not about replacing hedge funds altogether, but about minimising the resource budget that currently goes into (beta-dominated) diversified funds of funds in order to maximise the impact of high-alpha allocations.