In the year since Lo and Hasanhodzic floated the idea of hedge fund replication, a.k.a. hedge fund cloning, there has been plenty of discussion debunking the concept. But a lot of it gets bogged down in statistical minutiae.
What astonishes me is that major players keep on rolling out replication products — Goldman Sachs’ Absolute Return Tracker, Merrill Lynch’s Factor Index, Deutsche Bank’s Absolute Return Beta Index, JP Morgan…. This is either naive or sarcastic, as a simple explanation should show:
Clones claim that they can produce the same returns as hedge funds by taking positions in tradable indices. Well, not exactly … they actually aim to produce the same returns as benchmarks of hedge funds, which are notoriously problematic for reasons detailed elsewhere.
Why is this a stupid exercise?
1. To the extent that hedge fund returns can be replicated with some linear combination of indices, the hedge funds are not doing their job of producing alpha, which is defined as producing returns that are uncorrelated with tradable indices. Granted, there are plenty of “hedge funds” out there that are selling a lot of beta. Pity the investor paying 2%-and-20% for beta, but don’t try to mimic him.
2. The replicators are explicitly trying to match a hedge fund benchmark — which people only want because it represents alpha — by constructing a basket of beta to match it. Mathematically we know that with a big enough “basis” of beta instruments we can construct a basket that will match any return history. But, having fit this basket to the history, will it match the returns going forward? Again, if it does then it means that the target benchmark has no alpha component. If it doesn’t, then you failed to capture any alpha. Either way the clone investor loses — all he gets is beta! (And insofar as hedge funds are adding any value by timing beta, that timing is being lagged by the cloner!)
3. Why clone the returns of a suspect hedge fund benchmark — indeed, one that represents returns after the hedge funds’ notoriously high fees? Wouldn’t you rather replicate the returns of hedge funds before fees? How about an ideal hedge fund index that is completely uncorrelated with beta? Oops, that’s mathematically impossible … no matter: What investors really want is high returns with low risk. So why not clone a return series that exactly matches LIBOR + 3%? And if we can do that, how about absolute returns of 100%?
No matter how you slice it, if hedge fund benchmarks are replicable with liquid securities then both the benchmarks and the replications are useless as sources of alpha.