Hedge Fund Indexation And Replication

October 23, 2013


Respondents to Geczy's survey also expressed concern about "model risk," by which they meant the dependence of replication models on backtests of time series data. Inevitable and unknowable differences between past and future financial environments may make such systematic trading prone to large amounts of tracking error.7 The consultants surveyed also had negative views of the passive management of replication strategies.

Using Replication Strategies To Manage Investments
Products that replicate hedge fund returns with a high degree of accuracy can aid portfolio managers in different ways: as investable benchmarks, investment substitutes and complements to alternative asset portfolios. The benchmark application simply sets a standard against which investors may measure the performance of their own hedge funds individually or their hedge fund portfolio as a whole. While no replication fund is identical to any individual hedge fund, a relatively high correlation between the returns and volatility of a fund or a portfolio and a replication strategy in which one can invest makes the latter a legitimate performance benchmark (Figure 2).


Investors managing diversified hedge fund portfolios may increase their liquidity by substituting a liquid replication product for direct investments in hedge funds. Replication strategies have three uses as investment substitutes: core/satellite; transition tool; and long-only equity substitute. In the core/satellite approach to portfolio management, a manager builds a ring of alternative investments in more esoteric and possibly less liquid assets around a liquid core of one or more replication products. If the replication products are simpler to understand and easier to buy and sell than hedge funds, then a manager can devote more analytical resources to the more exotic strategies, while preserving the core alternative returns of the asset class with the replication strategies.

Portfolio managers may use replication products as transition tools to alter their alternative exposures quickly while they wait to invest in or redeem from hedge funds that offer only intermittent liquidity. For example, a manager who wishes to decrease exposure to a particular hedge fund strategy could use a short position in a liquid replication product to attempt to offset long exposure from funds scheduled for redemption in a few months. Similarly, a long position in a replication product could provide some positive exposure to an alternative sector while managers search for a long-term allocation.

As replication products become available as mutual funds or ETFs, some investors may treat them simply as another type of equity investment. Because they can capture the behavior of partially hedged portfolios of conventional assets, most alternative assets have significant positive correlations to conventional assets. In many instances, these correlations may make replication products behave like slightly out-of-the-money call options on long-only positions in equity or fixed-income indexes and funds linked to them.8 As such, investors who do not trade options themselves may use the replication products instead. Additionally, options traders may find them interesting as delta-hedging vehicles for out-of-the-money puts and calls.


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