Owing in part to its tremendously prolific promotional department, few in the hedge fund industry are unaware that EDHEC Risk and Asset Management Research Centre – an off-shoot of the renowned Edhec Business School in France – is releasing its latest research on hedge fund replication today (Thursday) at a seminar in London. The paper’s title summarizes Edhec’s take on the state of the replication world today: “The Myths and Limits of Passive Hedge Fund Replication: An Attractive Concept…Still a Work in Progress”.
While the full paper isn’t yet available to the public, our friends at Edhec have provided AllAboutAlpha.com with an copy so we can give you some of the main points.
Overall, we find it to be a very good survey of the state of the replication field. In the words of the authors, Noel Amenc, Walter Gehin, Lionel Martellini (Hall of Fame, related posting), and Jean-Christophe Meyfredi:
“The purpose of this position paper is to provide an in-depth analysis of the subject, with an emphasis on the findings based on the last ten years of academic research on hedge fund performance analysis and replication, and a discussion of the implementation challenges related to a commercial offering based on these concepts.”
The paper reaches two broad conclusions:
- that factor-based replication has “mostly failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis“, and,
- that pay-off distribution approach (a la Harry Kat) generates “relatively satisfying results on an out-of-sample basis”, but “cannot be a method suitable for performing hedge fund replication, at least not in a sense likely to meet investors’ expectations“.
The report goes on to say that the fundamental flaw with factor replication is the current lack of appropriate non-linear or dynamic factor models. Meanwhile, the problem with the pay-off distribution approach is that it is “much more about fund design than about hedge fund replication” (a fact which they point out is also acknowledged by its proponents). In addition, the paper echoes a point raised by Northwater Capital in their recent critique of hedge fund replication techniques – that the returns of a distributional replication are contingent on the choice of inputs (see related posting).
The first half of the report is a comprehensive and concise review of the last ten years of academic research on the topic of hedge fund alpha and (later) hedge fund replication. For example, the report’s contention that factor models are less than “satifying” is backed up by a table showing r-squares in the 30% to 70% range (in-sample), with out-of-sample data being much worse. The authors then re-run the approach used by Andrew Lo (see related posting) and find similarly “unsatisfying” results.
Wonder the authors:
“Since academic attempts to design factor models for hedge fund return replication have so far been unable to generate fully satisfactory results, the recent launch of a number of industry initiatives is perhaps surprising.”
The report then goes on to explain the so-called “Pay-off Distribution Approach” pioneered by Harry Kat. I find Kat’s approach is so hard to understand without an options background that I barely have a grasp of its basic mechanics on a good day (and I’ve written, like 5 or 10 postings on it). But this report contains what is probably the best chance any of us have to understand how the approach actually works. Here’s an excerpt:
“The principle of payoff replication is very simple and inspired from derivative pricing theory. It is based on the following two-step process. The first step consists of estimating the payoff function “g” that maps an index return onto a hedge fund return, while the second step consists of pricing the pay-off and deriving the replication strategy…”
The report goes on to say that the approach works “relatively well” at matching the properties of hedge fund distributions (means aside), but that:
“…the average return obtained for the clone is always (significantly) lower than that of the index on our out-of-sample period, which can be explained by the bear market (March 2000-March 2003) which spans a sizable fraction of the out-of-sample period. This result suggests that extreme caution should be used in choosing the reserve asset, and that the performance results of the replicating strategy are not robust with respect to the choice of the risky asset involved and the sample period considered.”
Later, the report reiterates this caution by stating that, for an investor with “more limited patience“, distributional replication can lead to “severe disappointment“. Furthermore, it suggests that higher transaction costs for the strategy “are bound to further impact the performance” achieved using this approach.
In the end, Edhec says neither hedge fund replication approach is ready for prime time. However, all may not be lost. In an idea reminiscent of Tony Blair’s “third way”, the researchers suggest a hybrid solution:
“Overall, it seems that it is only by combining the best of the two competing approaches that one can possibly hope to achieve truly satisfying results: the factor approach could facilitate time-series replication while the pay-off distribution approach could help generate the replicating portfolio for non-linear factors…”
The report is packed with data and results from previous studies and from Edhec’s own reconstruction of each methodology. If you didn’t attend Edhec’s seminar today in London, you can still order a copy (for 750 Euros) by contacting Edhec at AMeducation@edhec.edu or by phone at +33 493 187 819.
And while you wait for your copy to arrive, you may also want to check out AllAboutAlpha’s Hedge Fund Replication dossier (free and easy registration required). This area of our website now contains abstracts and links to around 20 papers from most of the key researchers in this field (e.g. Andrew Lo, Bill Fung, David Hsieh, Walter Gehin, Lars Jaeger, Harry Kat, Thomas Schneeweis and friends). And while you’re there, we’d also suggest you stop by the Portable Alpha and 130/30 dossiers and another one dedicated to research into the question of investment fees (everyone’s favorite topic).