Sweden’s €9bn AP7 has made an entry into hedge fund replication using a Goldman Sachs absolute return tracker (ART). CIO Richard Grottheim plans to replace the fund’s €170m FOHF position with hedge fund replication. The fund had already reduced its allocation to hedge funds in 2007 from 4% to 2% partly due to lower than expected returns.

 
AP7 expects to generate the same returns by investing in the same risk factors that drive hedge fund returns. The move is a first for AP7 which first invested in hedge funds in 2002. “It is not that we did not like the managers, but generally, FOHFs have been delivering lower returns than we expected,” says Grottheim. The FOHFs allocation generated 5-7% returns after fees compared to expectations of 8-10%.

 
In the past year, a growing number of investment banks, such as Goldman Sachs, Deutsche Bank, JP Morgan and Merrill Lynch, have been offering cloning products. One of the first was the Merrill Lynch Factor Index, which aims to replicate the HFRI Composite, a basket of 1,800 hedge funds pursuing different strategies. One of the benefits of replication is diversification. Critics, however, argue that because the Factor Index is so well diversified, the peculiarities of various hedge fund strategies are often lost. The result is often an index with mostly traditional rather than alternative risk exposures. Goldman Sachs’ replication products have shown the “best performance and highest correlation to the underlying broad hedge fund indices,” according to Grottheim.

 
Grottheim points to a number of reasons for the switch from an active to passive alternative beta strategy. He pays particular attention to media risk associated with being a public entity with a high level of transparency: AP7 was invested in the hedge fund Amaranth, which collapsed in 2006, and more recently in a Bear Stearns hedge fund. While the losses from their collapse proved to be relatively small, “the energy that management has to give to explaining and trying to cope with media risk in this respect is quite high. If you use replication products, you do not have this risk because you are no longer exposed to an underlying hedge fund. Even if you diversify among 15 to 20 underlying managers, sooner or later one will blow up.”

 
Replication products also cost between 75 to 100bps without a performance fee, less than a third on average of FOHFs, he says. “If hedge fund replication products can deliver a bond return plus 2% at a lower cost with the same level of risk, then we are happy with this and they have been delivering this if you back-test for the last two years.”

 
AP7’s portfolio, which is 80% externally managed, is invested 20% in Swedish equities, 52% in global equities, 10% in emerging market equities, 8% in fixed-income, 8% in fund-of-fund private equity and 2% in hedge fund replication. Seventy percent of the fund is passively managed.

VB