For many years, academic research has shown that hedge fund returns, like those of individual securities and mutual funds, comprise systematic ("beta") and idiosyncratic ("alpha") components. (Investments in hedge funds are speculative and entail substantial risk. Hedge funds typically use leverage that can magnify losses and engage in short-selling that can result in the entire loss of a principal amount invested.) William Sharpe , William Fung and David Hsieh [1997, 2000, 2001, 2002, 2004] and Andrew Lo and Jasmina Hasanhodzic  have written most prominently on this topic. More recently, this research has motivated fund managers, some with academic roots,1 to attempt to reproduce hedge fund returns with compact portfolios of conventional assets, such as exchange-traded products. For most of that time, however, investors seem to have shown far less interest in this work than the managers and academics conducting it.
The mixed performance of some of the early replication efforts may explain part of this indifference, but more significantly, before 2008, hedge fund replication was largely a solution to a problem no investors seemed to have. The conventional model of hedge fund investing that tolerated the illiquidity and lack of transparency of hedge funds in exchange for their uncorrelated returns had not yet broken. After 2008, interest in replication began to grow as investors sought remedies for three glaring problems they encountered with their hedge fund investments in 2008.
- Transparency − some hedge fund portfolios contained assets not fully disclosed in their offering memoranda.
- Liquidity − some managers could not or did not liquidate investments as required to meet redemption requests.
- Fidelity − some portfolio valuations turned out to be inaccurate.
Stung by these problems, some investors began to look more favorably at efforts to capture some of the returns of hedge funds without their relative structural disadvantages (i.e., illiquidity and general lack of transparency) as a potential component of their alternative investment allocations. Their interest, which is still modest in comparison to the direct demand for hedge funds, has produced a nascent asset class of exchange-traded products, mutual funds and separately managed accounts that all attempt in a variety of ways to marry the return profiles of hedge funds with the liquidity, transparency and business risk of more conventional investment funds.
This article describes in general the three main analytical approaches to hedge fund replication today. It then discusses the factor-based approach, the most widely used of the three, in greater detail. Finally, it seeks to identify and answer the following basic questions about this relatively new asset class:
- How does hedge fund replication work?
- What benefits does hedge fund replication offer and what are its weaknesses?
- How can investors use replication strategies to help manage investments?
- What makes a factor-based replication strategy successful?
- How does hedge fund replication vary by hedge fund strategy?
- How have replication products performed?
Known variously as hedge fund replication, alternative beta, liquid alternatives or some combination thereof, these assets attempt to resolve many of the problems institutional investors experienced in 2008. In addition, they offer investors who are not otherwise eligible to invest in the alternative asset class access to alternative strategies.