Factor-Based Hedge Fund Replication with Risk Constraints

Abstract

The hedge fund industry has witnessed rapid growth over the last two decades, from as few as 300 funds in 1990 to about 9,000 funds today. Although there was a reduction both in the number of hedge funds and in their average level of leverage during the credit crisis of 2007–8, today total hedge fund investment amounts to $2.4 trillion (Stowell, 2010). In parallel with this rapid growth in the hedge fund industry, there has been increased demand from investors for products that deliver the returns of hedge funds at lower cost, and without the risks that are typically associated with hedge fund investment, such as illiquidity, lack of transparency, and management-specific risks. To meet this demand, investment banks and asset management firms have developed investment products, commonly known as “clones,” that seek to replicate hedge fund returns by employing statistical models or algorithmic trading strategies.