Hedge Fund Replication

Abstract

In theory, analogous to equity indices, hedge fund indices can provide broad exposure to hedge funds in a cost-effective manner. In practice, however, hedge fund indices are difficult to implement because direct investment in hedge funds is impractical. Unlike equities, hedge funds are not traded on liquid secondary markets and are often closed to new investment. A solution is hedge fund replication, which, rather than require direct investment in hedge funds, synthetically recreates hedge fund index returns by investing in portfolios that are exposed to the same underlying economic factors that drive hedge fund returns. This approach provides broad, cost-effective, hedge fund exposure and avoids the practical problems associated with direct hedge fund investment. As a consequence, such hedge fund clones exhibit lower tracking error and substantially higher raw and risk-adjusted returns than both investible and noninvestible hedge fund indices.