The Myths and Limits of Passive Hedge Replication
In this paper we provide a detailed critical analysis of various methodologies involved in the so-called passive replication of hedge fund returns, a subject that has sparked renewed interest following recent initiatives by major investment banks such as Merrill Lynch and Goldman Sachs.
Professor of Finance and Director of the EDHEC Risk and Asset Management Research Centre
Research Associate, EDHEC Risk and Asset Management Research Centre and Business Analyst, Atos Euronext Market Solutions
PhD, Professor of Finance and Scientific Director of the EDHEC Risk and Asset Management Research Centre
PhD, Professor of Finance and Research Associate with the EDHEC Risk and Asset Management Research Centr
In particular, we examine from both a theoretical and an empirical standpoint the respective benefits and limits of the two different and somewhat competing approaches to hedge fund replication, which are respectively known as "factor-based replication," and "payoff distribution replication." On the one hand, we argue that standard implementation efforts of the factor-based approach, arguably the most natural and straightforward way to tackle the hedge fund replication problem, have mostly failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis.
We also argue that the payoff distribution approach, on the other hand, while insightful and found to generate (relatively) satisfying results on an out-of-sample basis, unfortunately cannot be regarded as a method suitable for performing hedge fund replication, at least not in a sense likely to meet investors' expectations, due to its documented failure to match a number of relevant time-series properties of hedge fund returns. In conclusion, hedge fund replication, while obviously a powerful and attractive concept, is still, at least in terms of successful implementation, very much a work-in-progress. Our analysis suggests that it is only through the introduction of novel adapted econometric techniques allowing for a parsimonious statistical estimation of the dynamic and/or non-linear functions relating underlying factors to hedge fund returns that hedge fund replication could be turned from an attractive concept into a workable investment solution, and we discuss several possible directions for future research.
The Myths and Limits of Passive Hedge Replication...
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