Hedge fund replication using strategy specific factors

Abstract

Hedge funds have traditionally served wealthy individuals and institutional investors with the promise of delivering protection of capital and uncorrelated positive returns irrespective of market direction, allowing them to better manage portfolio risk. However, the financial crisis of 2008 has heightened investor sensitivity to the high fees, illiquidity, lack of transparency, and lockup periods typically associated with hedge funds. Hedge fund replication products, or clones, seek to answer these challenges by providing daily liquidity, transparency, and immediate exposure to a desired hedge fund strategy. Nonetheless, although lowering cost and adding simplicity by using a common set of factors, traditional replication products might offer lower risk-reward performance compared to hedge funds. This research explores hedge fund replication further by examining the importance of constructing clones with specific factors relevant to each hedge fund strategy, and then compares the strategy specific clone risk and reward performance against both actual hedge fund performance and hedge fund clones constructed using a more general set of common factors. Testing shows that using strategy specific factors to replicate common hedge fund strategies can offer superior risk-reward performance compared to previous general model clones.