Abstract

Fully spanning the space of potential risk factors with tradable liquid portfolios is paramount in the context of a risk-based factor model. We develop a factor selection methodology of spanning the space of hedge fund risk factors with all available exchange traded funds (ETFs). We demonstrate the efficacy of the methodology with out-of-sample hedge fund return replication, and find that the replication accuracy increases with the number of ETFs available. This is consistent with our interpretation of ETF returns as proxies to alternative risk factors driving hedge fund returns.

We further consider portfolios of “cloneable” and “non-cloneable” hedge funds, defined as top and bottom in-sample R2 matches. We find superior risk-adjusted performance for “non-cloneable” funds, while “cloneable” funds fail to deliver significantly positive risk-adjusted performance. Our methodology provides value in both identifying skilled managers of “non-cloneable” hedge funds, as well as successfully replicating out-of-sample returns that are due to alternative risk exposures of “cloneable” hedge funds, thus providing a transparent and liquid alternative to investors who may find these return patterns attractive.

 

1. Introduction

Hedge funds have experienced tremendous growth in recent years, with more than $2.82 trillion currently invested in hedge funds globally,1 and are now considered an essential part of alternative investment strategies by institutional investors and financial institutions. Hedge funds have been able to produce returns with relatively low correlations with major asset classes, like stocks and bonds, due to the multitude of investment opportunities available to fund managers. Unlike managers of more traditional mutual funds, hedge fund managers have the flexibility to invest in non-traditional asset classes (including derivative securities), employ leverage, and engage in short sales. However, such strategies also expose investors to alternative risk factors that may not be easy to quantify, given the opacity of the hedge fund industry. It is then natural to question whether the returns earned by hedge fund managers are due to managerial skill, or merely compensation for exposure to alternative risk factors.2 If a significant portion of hedge fund returns comes from alternative risk factor exposures, then it is reasonable to presume that it is possible for investors to replicate that part of hedge fund returns at a lower cost by taking on these risk exposures themselves. However, such an exercise hinges on the investor’s ability to identify and quantify these alternative risk factors via proxies of portfolios of tradable and liquid securities.3 That is why the issue of choosing appropriate risk factors is central to any study of…