We argue that only hedge funds whose returns are driven by beta management of exposures to latent risk factors could be successfully replicated. We develop a methodology for creating a portfolio of ETFs that replicates risk factor exposures taken by top beta active cloneable hedge funds. The strategy could be interpreted as cloning beta exposures of the best beta active hedge funds, and it delivers outstanding long- term risk-adjusted performance. The ETF portfolio only requires annual rebalancing, and is constructed with a transparent algorithmic approach, which conforms to a definition of a smart beta strategy.


1. Introduction

Hedge funds, which experienced tremendous growth in recent years with more than $2.82 trillion in global investments currently under management,1 are widely criticized for their lack of transparency, liquidity, and hefty 2-20 fee structures. Numerous attempts at cloning hedge fund returns with liquid investment alternatives have been made in academic literature2 and also among major asset management companies.3 Ideally, hedge fund clones should alleviate all three major problems with hedge funds by providing transparency and liquidity at much lower costs. However, it is not clear that hedge fund returns can be replicated in the first place, as truly active proprietary fund management strategies could be beyond replication efforts.4 For example, the S.A.C. Capital Advisors’ strategy in trading Elan and Wyeth stocks based on insider tips obviously can’t be replicated with any algorithmic approach.5 But as John H. Cochrane observes, hedge fund returns may be predominantly driven by beta exposures to latent risk factors not readily discernible to average investors:

As I look across the hedge fund universe, 90% of what I see is not “picking assets to exploit information not reflected in prices,” it is “taking exposure to factors that managers understand and can trade better than clients.”

If hedge fund returns are indeed driven by alternative risk factor exposures,7 then it is reasonable to presume that it is possible to come up with a procedure for replicating hedge fund returns at a lower cost with a portfolio of alternative risk factors. The factor approach to hedge fund cloning is being employed by Hasanhodzic and Lo (2007), Amenc, Martellini, Meyfredi, and Ziemann (2010), Giamouridis and Paterlini (2010), and Weber and Peres (2013). There are, however, two problems with prevailing methods. First, only a limited number of potential risk factors8 are considered. Second, the prevailing focus is on replicating either all individual hedge funds or broad hedge fund indexes without regard to the fact that some hedge fund strategies are, in fact, non-reproducible.

In this paper, we address the two issues above by following the methodology detailed in Duamnu, Li, and Malakhov (2014) (DLM thereafter). First, the DLM methodology spans the space of potential risk factors with all available ETFs, thus it greatly expands…