Hedge fund replication aims to track the aggregate performance of hedge funds (as represented by a hedge fund index) using liquid, daily tradable instruments, without investing directly in hedge funds and there are several different ways to replicate hedge fund returns.
We use the factor replication technique in our ING Alternative Beta Fund, which works
on the premise that a substantial part of aggregate hedge fund returns are driven by systematic risk premia, reflected by market factors like equity prices, interest rates, market volatility and Forex rates.
By analysing aggregate hedge fund returns, factor replication aims to determine the dynamic exposure of the hedge fund industry to these factors.
The hedge fund industry is a dynamic and complex environment at first sight. A sophisticated quantitative approach is needed to reveal the risk and return drivers of the aggregate industry. However, before this quantitative approach can be turned into an investment opportunity a number of challenges should be addressed properly, including:
• Factor selection: All factors should have a fundamental link to the hedge fund industry, meaning the factors used should be a reflection of the risk premia that drives the hedge fund industry
• Model specification: Defining the model specifications should deal with statistical pitfalls like ‘over-fitting’
• Portfolio construction: efficient portfolio construction should minimise the performance drag caused by transaction costs resulting from large turnover
• Proper risk management: not only market risk, but counterparty risk, collateral management and regulatory requirements, to name a few, should be covered by sound risk management and continuous monitoring
There are several advantages of a factor replication approach. Since factor replicators do not invest in hedge funds, the double fee layer issue is not applicable, meaning a competitively priced product can be offered.
Also, the instruments and factors being used by fund managers are tradable daily, and this liquidity is also present at the fund level.
Daily tradability of the fund should reduce the fear for ‘checking in any time you like, but never leave’ – although it should also be noted that unique uncorrelated alpha capabilities of some hedge funds managers out there can never be replicated.
In order to not to miss out on those opportunities, it could be argued that it makes sense to complement alternative beta exposure (liquid and at low costs) with some carefully selected ‘true alpha’ producing hedge fund managers, a so-called core/satellite approach.
If an investor is confident they can pick the best performing hedge funds and spot the negative outliers, then they should go-ahead and invest directly in individual managers if they’re able to. But if they’re not sure of their skills in these respects, and want to capture the broad investment returns of the industry, then they should consider hedge fund replication funds.They would benefit from the strict regulatory oversight of the market (often Ucits-compliant funds) and the easy access to their money that stems from investing in liquid underlying instruments.