In addition to a useful index, a replicator needs access to tradable proxies for the risk factors that drive the returns of a particular index. The recent proliferation of ETFs and the abundance of futures contracts traded on various exchanges offer a plethora of such proxies, but some risk factors remain difficult to capture with a single liquid asset. A replicator can capture changes in equity indexs, interest rates on government bonds, commodity prices and foreign exchange with extremely liquid and easily valued instruments. In contrast, exposure to credit risk—while easily identified by regression analysis—is difficult to obtain because of the illiquidity, lack of transparency, and basis risk posed by credit derivatives. Additionally, tracking errors in commodity ETFs—such as those caused by the transaction costs of rolling futures contracts—create portfolio management challenges for replicators inclined to use them.
How Does Hedge Fund Replication Vary By Hedge Fund Strategy?
Only some hedge fund strategies produce indexes with both strong beta signals and serial correlation, as described in the previous section. Hedge fund strategies typically differ from each other in two dimensions: the level of turnover in the assets held by the funds; and the number of trading strategies their managers employ to implement them. Research shows that strategies with low portfolio turnover and fewer trading strategies tend to produce more robust risk-factor correlations than strategies with high portfolio turnover and more trading strategies. Furthermore, our research shows that directional strategies of hedge funds that focus on fundamental analysis of corporate securities, such as long/short equity, event-driven equity, and credit fixed income, yield the highest R2 statistics. In contrast, relative value and arbitrage strategies with high rates of portfolio turnover, such as statistical arbitrage and volatility arbitrage, produce very low R2 statistics. That makes them poor candidates for replication strategies.
Figure 3 shows the R2 statistics for risk-factor regressions of hedge fund indexes computed from the monthly returns of more than 5,000 hedge funds for the period from 2001-2010.
These results suggest to us that hedge fund replicators ought to focus their efforts narrowly on those strategies for which one can identify strong risk-factor correlations. Because this limits the scope of its applicability, we believe hedge fund replication seems likely to serve portfolio managers best as an additional tool of a broader alternative investment strategy. Investors who seek exposure to the return profile of hedge fund strategies amenable to replication with more liquidity and transparency than that available from direct investments in hedge funds or funds of hedge funds may benefit from hedge fund replication. Proponents of replication who attempt to apply it more broadly than that may undermine their own efforts by overstating its strengths.
Replication Product Performance
To earn a place in investor portfolios, we believe hedge fund replication products must deliver performance that meets reasonable expectations based on their structural similarities and differences with the hedge fund indexes they aim to reproduce. Beta constitutes the primary similarity between the replicas and the indexes. The alpha of the hedge fund indexes and its absence from the replication products differentiates them, but so too do the transactional differences mentioned at the beginning of this paper—transparency, liquidity and fidelity.