Financial analysts have a special name for the beta of the undefined factor. They call it "alpha," and in the business of marketing individual hedge funds, have bestowed upon it plaudits like "managerial skill" that can potentially exaggerate its statistical meaning. The beta of the constant term in a multivariate regression of hedge fund returns, or "alpha"—as virtually all financial analysts and fund managers call it—is simply the correlation of those returns with nonrandom phenomena not identified elsewhere in the regression. A failure to identify nonrandom behavior in the returns of a single hedge fund may signify something about a fund's management, but it may also reveal only an analyst's failure to consider the right combination of risk factors in the regression. At the index level, alpha indicates that the strategy as a whole identifies some behavioral pattern in markets. The inability to identify an investable proxy for such a pattern means that factor-based replication cannot reproduce it in an investable form.
The nonrandom returns explained collectively by these correlations with known risk factors constitute the systematic return or "beta" of the hedge fund index. Factor-based replication products aim to reproduce this hedge fund beta with portfolios of investable proxies for the individual regression betas. Generally such proxies comprise exchange-traded funds and notes ("ETPs"), government bonds, interest rate and commodity futures contracts, and foreign exchange in proportions equal to the regression betas. Again, since no ETF exists for alpha, factor-based replicators can only seek to reproduce hedge fund beta.
Benefits And Weaknesses
In late 2009 and early 2010, Geczy  surveyed the 50 largest institutional investment consultants by assets under advisement to obtain their views of the most important issues then facing their hedge fund investors. He received responses from 15 consultants advising on collectively more than $7 trillion. All of them cited a need for greater transparency, and most also indicated preferences for lower fees, greater liquidity and more due diligence on target hedge funds.6 Replication strategies aim to address all of these issues directly.
Real-time publication of holdings, common for most replication strategies, solves the transparency issue. If such holdings include only highly liquid assets such as listed securities, government bonds, futures contracts and foreign exchange, the funds themselves can offer their investors continuous liquidity. Many of the replication products currently available to investors do that. When implemented in a passive and systematic manner using only the weights computed by the regression analysis and no discretion, replication funds may cost much less to manage than actively managed hedge funds. Replication funds can pass these savings along to investors in the form of lower fees. Finally, as long as replication funds do not invest in any instruments associated with individual managers, as with funds of hedge funds, they pose no headline or fraud risk.
Hedge funds attract many types of investors, from high net worth individuals to university endowments and pension funds. These investors vary in their abilities to evaluate and monitor the hedge funds in which they invest. Sophisticated individual investors, especially those with backgrounds in finance, and large institutional investors with significant analytical and operational support teams, can and usually do manage their own hedge fund investments. In contrast, investors without expertise in finance or the resources to acquire it may rely on consultants or fund-of-hedge-fund managers to screen hedge funds for them. In general, large investors tend to invest directly, while smaller ones often invest via funds of hedge funds. On a purely operational level, hedge fund replication may reduce the amount of work and thus the cost of evaluating and monitoring hedge fund investments for all of these investors.