With hedge fund performance starting to look up, a reader recently suggested we check up on the trials and tribulations of “hedge fund replicators” - those who aim to clone the returns of hedge funds via passive exposure to highly liquid and ubiquitous investments.  The most well understood method of doing is to use a factor model based on a trailing regression of hedge fund industry returns.  One of the most prominent players in this space is probably Merrill Lynch, purveyors of the “Merrill Lynch Factor Model” (factor model website).

The firm describes the index this way in its marketing sheet:

“The Merrill Lynch Factor Model (the “Model”) is designed to provide a high correlation to “hedge fund beta,” the portion of hedge fund returns which can be explained by exposure to certain market measures, and not individual manager skill. To accomplish this, the Model seeks to emulate the performance of the HFRI Fund Weighted Composite Index (the “HFRI Composite Index”) using the publicly reported prices of a basket of liquid, well-known market measures.  The HFRI Composite Index is a non-investable index which tracks the performance of over 2,000 hedge funds on a monthly basis.”

So how has it done at “emulating” the HFRI?  According to Merrill’s data, pretty well.  Although its marketing sheet hasn’t been updated since the end of 2007, raw data provided on the product’s website shows the Factor Model and the HFRI Composite have a rolling 24 month r-squared of about 0.9 over the past several years. More…

In just about every action movie and TV show these days there is at least one scene where the hero asks one of his or her techies to “sharpen” a satellite image.  Suddenly, what looked like a fuzzy bunch of pixelated squares takes on the form of someone’s face, a car, or some kind of mobile rocket launcher.   We’re not graphic imaging specialists.  But to us, it looks kind of outlandish that someone could take a very small amount of information (a few pixels) and divine the underlying image in fantastic detail.

But in a way, that’s exactly what Daniel Li & Michael Markov (of quantitative investment software vendor Markov Processes) and Russ Wermers of the University of Maryland have done in a paper released last month called “Monitoring Daily Hedge Fund Performance When Only Monthly Data is Available.”  Their trick is to leverage another kind of technology: hedge fund replication.

As we have reported extensively, “linear factor replication” aims to predict the performance of hedge funds based on a multiple regression of their historical returns on a number of variables such as equities, Fama/French factors, and several more “exotic” risk factors. More…

Passive investment in hedge funds has always been somewhat of an oxymoron.  Hedge funds, after all, aim to deliver active management (alpha).  And since alpha is a zero sum game, a passive investment in hedge funds should deliver a zero return.  Nonetheless, this axiom has always been challenged by proponents of various products designed to deliver aggregate “hedge fund returns”.

First there was the passive fund of funds; then came the investable hedge fund index; and finally there was hedge fund replication.  In essence, all of these products delivered similar value propositions: diversification, transparency, and liquidity.  (Despite the tendency for these providers to compete on returns, out-performance was never officially the goal of these “passive” products).

Hedge fund replication seemed to be the story of the year in 2008.  But in the post-Madoff environment, the pendulum may be swinging back in the other direction.  The investable hedge fund index - derided by proponents of hedge fund replication as being expensive and opaque since it invests in hedge funds themselves - is making a comeback. More…

Looks who’s making a return trip to the news after being largely tossed away by the media last year.  It’s alternative beta and 130/30.  As regular readers will recall, these hedge fund relatives seems to have died off last fall.  But this week, several firms announced new funds aimed at resurrecting interest in “hedge fund replication” and “short-extension” strategies.  And who knows, the time may now be right for these quasi-hedge fund instruments.

Clones or Zombies Back from the Dead

Hedge Funds Review reported today that Invesco, the mutual fund giant, launched an alternative beta strategy called “Premia Plus” (not to be confused with Premium Plus, the perfectly flaky cracker from Kraft).  Without calling itself a “hedge fund” (now a four letter word in the post-12/11 environment), the company borrows heavily from the hedge fund lexicon.  According to Hedge Funds Review, Invesco says it has developed a proprietary risk management strategy that “could generate equity-like returns with bond-like risk.”

The magazine also reports that Invesco is emphasizing many of the now de rigueur qualities of liquidity, low price and “transparency”.  (Although we wonder how useful “transparency” really is when the product still uses a “proprietary risk management and rebalancing technique”).

Not content to let Premia Plus steal the headlines, Barclays Capital just launched the “Barclays Alternatives Replication” Index last week.  The index comes in long and short versions called LBAR and SBAR (much like Innocap’s products and T-Rex offered by Socgen).  Barclays says that LBAR tracked the HFRI better than “four main competing hedge fund indexes” last year.  This statement is a refreshing change in a field where companies often seem to compete on the basis of performance, not tracking error.

Why the reincarnated interest in hedge fund replication?  According to Reuters: More…

Newly-released government UFO files aren’t the only controversies pitting skeptics against “believers” these days…

Hedge fund replication is back in the news today with the publication of the results from a survey on the topic conducted last winter by French research institute Edhec Risk and Asset Management Research Centre.  While the results are somewhat dated, they are a good recap of the concept as a lead-up to Edhec’s annual alternative investment conference in London in a couple of weeks (Edhec’s “Alternative Investment Days“).  The bottom line: polarization between those who believe there may be some value in the exercise and those who ridicule it as a hoax.

Regular readers may recall our own poll on this topic (conducted in partnership with conference producer Terrapinn) conducted around the same time (winter 2008).  We were curious to see if our findings lined up with those of Edhec and were encouraged to see that both surveys seemed to have yielded roughly the same results - with a few notable exceptions.  Edhec’s sample was about the same size as ours with slightly more asset managers and fewer end investors.  While we did not ask about geography, Edhec notes that its sample was predominantly European.  As we wrote in the commentary for our recent 130/30 survey, respondents to surveys like this are likely to be skewed toward those with an existing interest in the topic.  As a result, caution should be used in extrapolating the results (of both surveys).

More…

The Fall issue of the Journal of Alternative Investments contains a great 75 page section on hedge fund replication.  Articles cover the latest developments in the two major techniques used to approximate hedge fund returns (factor and distributional replication), performance characteristics of actual hedge fund replication programs, and practical hurdles to implementing these programs.

These articles have begun to attract interest from the hedge fund and broader financial communities.  One paper by Jean-Francois Bacmann, Ryan Held, Pierre Jeanneret and Stefan Scholz called “The impact of missing factors on replication quality” has caught the eye of AllAboutAlpha.com contributor Pierre Laroche, head of R&D and Innocap, a joint venture between Canada’s National Bank and BNP Paribas (related post).  Below, Laroche examines the delicate balance between adding too many factors and too few factors in a factor-replication model.

Special to AllAboutAlpha.com by: Pierre Laroche, Managing Director, R&D, Innocap Investment Management.

The issue of “missing factors” was raised soon after several major financial institutions launched their HF index replicators last year.  The use of traditional regressions by these products raised some questions about the number of factors required to fully capture the nuances of HF returns.  Specifically, the more factors one adds, the more likely those factors are to be collinear (correlated), thus lowering the regressors’ efficiency. This property of regression-based HF replicators (along with other properties such as their inability to track abrupt changes in weights) pushed financial institutions to look for more appropriate tracking models.  One such model is the “Kalman Filter” (KF).

KFs can contribute greatly to hedge fund replication models for at least two reasons:

• Their tracking algorithm explicitly takes into account that exposure to return-generating factors are dynamic (they vary through time).
• The quality of the estimated weights is impacted much less by the presence of highly correlated factors.

In other words, KFs are influenced less by using a small number of highly correlated factors.  Unfortunately, however, they do not settle the central question of the ideal number of factors to use when trying to “replicate” HF returns. More…