Synthetic Funds and the Mongolian Barbeque
Nov 26th, 2006 | Filed under: Alternative Beta & Hedge Fund ReplicationBy: Harry Kat & Helder Palaro, Cass Business School, City University London
Published: August 7, 2006
As we’ve recently noted, one of the spiritual leaders of the emerging “hedge fund cloning movement” is Professor Harry Kat of the Cass Business School at City University in London.
Professor Kat has written a series of papers in the past 2 years that detail a proposed hedge fund cloning process. He has been particularly prolific in 2006 when (so far) he has posted no less than 7 papers to the Social Science Research Network, an international clearinghouse for academic research. Recently, this research was mentioned in both the Economist and Newsweek.
We’ll spend some of this week discussing Kat’s papers – which amount to a sort of trilogy of hedge fund factor analyses. In their first paper, Kat and co-author Helder Palaro propose a hedge fund factor analysis methodology to uncover true alpha. In their second, they apply this methodology to nearly 2000 hedge funds to assess performance. And in their third (discussed below), they show how this analysis technique might be used to clone hedge funds.
With an apparent nod to The Spice Girls, Kat and Palaro penned a working paper earlier this year called Tell Me What You Want, What You Really, Really, Want!. In this paper, the authors test their synthetic hedge fund replication ideas. The abstract:
In a set of four out-of-sample tests over the period March 1995 - April 2006 we show that the Kat and Palaro (2005) strategies are indeed capable of accurately generating returns with a variety of properties, including negative correlation with stocks and bonds and high positive skewness. Under difficult conditions, the synthetic funds also produce impressive average excess returns. Combined with their liquid and transparent nature, this confirms that synthetic funds are an attractive alternative to direct investment in popular alternative asset classes such as (funds of) hedge funds, commodities, etc.
In a non-technical summary of this paper entitled Synthetic Funds and the Mongolian Barbeque Kat and Palaro compare portfolio construction to the construction of an entrée at a local London restaurant near Kat’s home in London.
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[…] All About Alpha with more on the “hedge fund cloning movement.” […]
[…] Ineichen’s conclusion: “…active risk managers need not worry any time soon” about being replaced by simple structured products.  (Professor Harry Kat, who argues that hedge funds can be closely approximated by dynamic (passive) trading strategies, might argue otherwise): “Structured products offer asymmetric return profiles that suit the loss-aversion properties of investors. However, the cost of these products narrows their return significantly. There is no alpha in those products. They typically lie below the capital market line, not above.” […]