Special to AllAboutAlpha.com by: Professor Harry Kat, Cass Business School

Driven by a desire to reduce costs and thereby improve investor returns, as well as to avoid the many other drawbacks surrounding hedge fund investment, such as illiquidity and lack of transparency, the market has recently seen several attempts to replicate hedge fund returns. The latter have received quite some attention in the media but judging from the comments made in the press, at conferences and on the internet, there seems to be a lot of confusion about what drives hedge fund return replication and what it is meant to achieve. In this brief note I will try to clarify a couple of important points.

Strict Replication is an Illusion

Put simply, hedge fund return replication is about generating hedge fund-like returns by mechanically (as opposed to discretionary) trading traditional asset classes. The term hedge fund-like can be interpreted in at least two different ways. One way is to require the synthetic fund returns to be the same as the real fund returns every month. I refer to this as strict replication. Another interpretation is to require only that the synthetic returns have the same characteristics as the fund returns. I refer to this as weak replication. Obviously, strict replication presents a much more ambitious goal than weak replication.

More…