Manager finds factor-replication “blunt” and distributional-replication “suspiciously opaque” – advocates mechanical trading instead
Jul 19th, 2007 | Filed under: Alternative Beta & Hedge Fund ReplicationSurveys of the hedge fund replication field often divide the various offerings into three distinct classes: factor models, distribution replication and mechanical trading. We hear a lot about factor models and now about distributional replication, but “mechanical trading” seems to be the neglected sibling in the cloning family.
Now one advocate of the mechanical trading approach, a CTA manager called Conquest Capital Group, has made their case in a paper available here at Eurekahedge. While a portion of the paper describes the benefits of their particular passive CTA replication fund (a managed futures beta replication strategy with “a fee schedule that is more appropriate for a beta product”), it does make a number of general observations about the field of hedge fund replication.
The authors base their arguments on several papers we have also discussed at AllAboutAlpha.com, namely: the March 2007 Edhec study on replication, Northwater’s recent survey of replication methodologies, Bridgewater’s 2005 observations about hedge fund correlations and Harry Kat’s original papers on distributional replication.
Other examples of the so-called mechanical-trading approach to hedge fund replication (cited by Kat in this paper) include: the Merrill Lynch Equity Volatility Arbitrage Index, the Merrill Lynch FX Clone, and Deutsche Bank’s Currency Return Index.
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Mechanical replication usually refers to creating a systematic version of a discretionary trading process. Trendfollower CTAs ARE systematic. Thus, what Conquest offers is not mechanical replication, it’s actually a trendfollowing system with low fees. It’s not beta at all.