Hedge fund replication uses a number of different methods in an attempt to duplicate traditional hedge fund returns. The main advantages of hedge fund replication include greater transparency, added liquidity and lower fees.
Hedge Fund Replication
Hedge fund replication attempts to emulate the return sources and corresponding risk exposures of hedge funds. Many people believe that the success of hedge funds is not due to manager skills but is a result of selective market-based exposures, also known as risk premiums. Most traditional hedge funds claim their return results from the manager's skills, but hedge fund replication supporters maintain this claim only serves as a basis to justify the layers of fees charged by traditional hedge funds. Replication strategies aim to offer the same returns as traditional hedge funds without the high fees associated with these funds.
Methodology
Hedge fund replication uses three primary strategies, factor replication, distribution replication and mechanical trading. With factor replication, an analyst identifies the factors that affect the returns of traditional hedge funds and creates a combination of assets with the same exposure to these factors. The distribution method attempts to generate a portfolio of traditional assets that have similar risk characteristics, and the mechanical trading method focuses on mimicking the manager activities of a traditional hedge fund.
Benefits
Hedge fund replication offers benefits to investors unable to invest in traditional hedge funds due to high initial costs or other limitations. Replication also removes the illiquidity, fraud risk and lack of transparency associated with traditional hedge funds. Additionally, hedge fund replication uses strategies that invest in liquid instruments and therefore, market liquidity issues affect replication methods to a lesser extent than traditional hedge funds. Further, replication methods typically impose fewer constraints on client withdrawals.
Effectiveness
According to an article that appeared in the "Financial Times," hedge fund replication offers up to 85 percent of the returns of a traditional hedge fund. The remaining 15 percent of returns results from the skills of hedge fund managers. However, the monetary value of the 15 percent is less than the fees associated with investing in a traditional hedge fund. Therefore, hedge fund replication is a viable investment strategy.
