Kat: HF replication using alternative betas very useful but sounds better on paper than in practice
| Feb 20th, 2008 | Filed under: Alternative Beta & Hedge Fund Replication, Guest Posts | By: Alpha Male |
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Not one to shy away from a debate, Professor Harry Kat responds to last week’s column by Dr. Lars Jaeger on traditional and alternative betas in hedge fund replication. While Kat agrees with several of Jaeger’s arguments, he wonders if the mechanical-trading approach to delivering alternative beta isn’t just too complex.
Some Comments on Lars Jaeger’s Hedge Fund Replication and Alternative Beta: Two different ways of looking at replicating hedge funds
Special to AllAboutAlpha.com by: Professor Harry Kat, Cass Business School, London
In a note last week on AllAboutAlpha.com, Lars Jaeger discussed the two most common approaches to hedge fund replication: factor models and mechanical trading rules designed to capture alternative betas. Although I agree with several of the points that he makes, his comments are only part of the hedge fund replication story. In this brief note, I will attempt to fill in the picture. Most of my comments can also be found in some of my earlier writings on the subject. But it doesn’t hurt to repeat them, however, as we need to be clear on the issue.
What is very important when trying to make sense of hedge fund replication products, is to keep an eye on what they actually aim to replicate. Almost without exception they aim to replicate, either explicitly or implicitly, a diversified hedge fund index. So hedge fund replication isn’t really about replicating hedge funds. It is about replicating hedge fund indices.
Does that matter? Isn’t a hedge fund index just a portfolio of hedge funds? Yes, it is. But therein lays the problem. When combining hedge funds into a portfolio, many typical hedge fund features diversify away. As a result, diversified hedge fund indices have only a few hedge fund-like properties left and are mainly driven by equity and credit risk. This is easily confirmed by calculating their correlation with the S&P 500 for example. The important conclusion from this is that we do not need alternative betas to replicate a diversified hedge fund index. As Jaeger also suggests, it is primarily driven by traditional betas. With precious little alternative beta actually present in a diversified hedge fund index, the main problem when replicating it is traditional beta.
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Regarding PGABS, it looks like they have the correlation down. Maybe we just need to give them ten years or so for the mean return to converge? I’m joking because I wouldn’t describe distributional replication as simple. At least, it is opaque enough to make a fair assessment difficult.
We can also point out examples of exceedingly simple and effective mechanical trading funds. Bloomberg:COMAFUT has consistent 85-90% correlation to managed futures indices – with comparable to superior performance, and managed futures is the most difficult style to replicate with the factor approach.
[...] One of our primary objectives at AllAboutAlpha.com is to encourage debate and discussion on emerging topics in investment management. That is why we cover new academic studies, surveys, counter-intuitive viewpoints and controversial opinions. Today, we bring you the latest in an ongoing debate between two well-known and highly regarded figures in the hedge fund industry, Professor Harry Kat of the Cass Business School and Dr. Lars Jaeger of fund manager Partners Group (previous postings: Jaeger…Kat…Jaeger…). Although Kat and Jaeger differ on many issues, they share a common interest in furthering the field of finance through frank, collegial and mutually-respectful debate. And judging from our traffic, so do you the reader. [...]