Can Hedge-Fund Returns Be Replicated?: The Linear Case

Abstract

Hedge funds are often cited as attractive investments because of their diversification benefits and distinctive risk profiles-in contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or "clones" using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we find that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds.

A Tail of Two Cities: On the Downside Risk and LossProfile of Asian and North American Hedge Funds

“…Factor-based risk-adjusted returns have also been applied by Fung and Hsieh [2004] for benchmarking hedge fund performance. Hasanhodzic and Lo [2007] extended this approach to replicating North American hedge fund returns, while Hakamada, Takahashi, and Yamamoto [2007] applied it to analyze Asian hedge fund returns.…”

Can typical households earn hedge fund returns? An analysis of the Eta® replication approach

“…As with Jaeger and Wagner (2005), Hasanhodzic and Lo (2007), and Amenc et al (2010), we assess the out-of-sample replication quality of the Eta model by attempting to clone the time-series characteristics of HMFs.…”

“…As fund managers adopt different trading strategies, ABS factors are identified that align themselves to these strategies ( Jaeger and Wagner, 2005), in contrast to the same set of factors for all strategies (Hasanhodzic and Lo, 2007). Sharpe (1992) introduced these style factor models to active equity mutual funds, which were subsequently extended by Fung and Hsieh (1997) to hedge funds.…”

Replicating the Properties of Hedge Fund Returns

“…A further advantage of this methodology is that if the linear model is wellspecified, one can attempt to replicate the returns of the hedge fund by investing in the appropriate portfolio of factors. A recent paper by Hasanhodzic and Lo (2007) provides some evidence that linear replication can be successful for certain strategies whilst offering certain advantages to hedge fund investing. These include more transparency, increased liquidity and fewer capacity constraints.…”