The prior post was about new ETFs that tracked different hedge fund strategies. There are other techniques used to replicate hedge fund returns without the negatives associated with such funds. Fund investments are not liquid, are opaque, have high fees and weak regulations. There are two methodologies to hedge fund replication: factor-based and payoff distribution replication. The study Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques by Noel Amenc, Walter Gehin, Lionel Martellini and Jean-Christophe Meyfredi of EDHEC studied both to determine their effectiveness.
The factor-based approach involves identifying the risk factors of hedge fund returns to build a portfolio that mirrors its performance. The difficulty lies in finding the right factors to build a model. They may be market factors such as interest rates, indices and credit risk or style factors such as futures and options. Most of the portfolios underperformed hedge funds and were more volatile. There were a number of causes for this. It is hard to create the proper model of risk factors. The factors are linear in nature. Hedge funds hold investments such as options with non-linear returns. Fund managers change their portfolio frequently. The factors cannot follow their changes accurately and timely.
The payoff distribution approach tries to replicate the distribution of hedge fund returns by finding an index return that matches the hedge fund return and pricing the payoff function using a standard option pricing model such as the Black-Scholes model. Amenc's study finds that the replication strategy works for a timeframe of six years or longer. It does not mimic the time-series properties of hedge fund returns.
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