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Following recent initiatives by major investment banks, there has been renewed interest in the financial industry concerning the subject of "passive hedge fund replication," a topic that had already been much discussed in academic circles over the last decade or so. In a nutshell, these initiatives are meant to enable investors to achieve returns similar to hedge funds' returns with significantly lower fees through investment in a set of rules-based strategies based on liquid underlying assets aimed at replicating hedge fund performance, or at least the systematic factor exposure in hedge fund returns, i.e., their (traditional and alternative) beta components, as opposed to their alpha components. Merrill Lynch and Goldman Sachs have been the first to announce the launch of hedge fund replication tools, with respectively the "Merrill Lynch Factor Index" and the "Goldman Sachs Absolute Return Tracker Index."
Other attempts to introduce heuristic trading rules aimed at replicating hedge fund manager decisions have recently been proposed and are summarized in Exhibit 1.
There exist in fact two different, somewhat competing, approaches to hedge fund replication, which are known as factor-based replication and payoff distribution replication. This article provides a critical assessment of both methods. Our conclusions can be broadly summarized as follows:
i) The factor-based approach, while the most natural and straightforward way to tackle the hedge fund replication problem, has mostly failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis. Intuitively, the reason why the method fails is rather simple: because of the nonlinear and dynamic exposure of hedge fund returns with respect to underlying risk factors, and in the absence of a true modeling of the time-variations in these factor exposures, simple stepwise linear regression techniques, which simply match the average past exposures of hedge fund managers to underlying risk factors, are bound to perform poorly on an out-of-sample basis. In other words, to capture the conditional distribution of hedge fund returns, which is what these strategies focus on, one would need to rely on truly conditional factor models, allowing for time-varying factor exposures. For most hedge fund strategies, such satisfactory dynamic models for hedge fund returns are unfortunately yet to be developed.
ii) The payoff distribution approach, while insightful and found to generate relatively satisfying results...