A Factor-Based Application to Hedge Fund Replication

Hedge fund returns are generally considered to be little correlated with market returns. Skills and dynamic strategies are claimed to generate more complex risk exposures that yield superior performance (alpha) or complementary sources of risk premium (alternative beta) through bear and bull markets by using a broad range of instruments, such as derivatives, leverage, short selling, and arbitrage across markets. This market neutrality feature of hedge funds would suggest that investing in hedge funds, either directly or through funds of hedge funds, could be an effective tool of portfolio diversification, hence making it appealing for a large range of institutional investors and high-wealth individuals. 1 However, hedge funds (1) provide limited liquidity, as resources are usually “locked up” for 1–3 years; (2) impose high management fees (up to 5 percent a year); and (3) offer poor transparency. These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.