Kat: HF Replication is an illusion that will never stick

Special to AllAboutAlpha.com by: Professor Harry Kat, Cass Business School

Driven by a desire to reduce costs and thereby improve investor returns, as well as to avoid the many other drawbacks surrounding hedge fund investment, such as illiquidity and lack of transparency, the market has recently seen several attempts to replicate hedge fund returns. The latter have received quite some attention in the media but judging from the comments made in the press, at conferences and on the internet, there seems to be a lot of confusion about what drives hedge fund return replication and what it is meant to achieve. In this brief note I will try to clarify a couple of important points.

Strict Replication is an Illusion

Put simply, hedge fund return replication is about generating hedge fund-like returns by mechanically (as opposed to discretionary) trading traditional asset classes. The term hedge fund-like can be interpreted in at least two different ways. One way is to require the synthetic fund returns to be the same as the real fund returns every month. I refer to this as strict replication. Another interpretation is to require only that the synthetic returns have the same characteristics as the fund returns. I refer to this as weak replication. Obviously, strict replication presents a much more ambitious goal than weak replication.

So far, most attempts to replicate hedge funds have concentrated on strict replication. The problem, however, is that most hedge funds dynamically trade in and out of markets and risk factors. Most hedge funds do not operate in different markets than traditional investors. They just follow different, more dynamic strategies. To achieve strict replication one will somehow have to capture the bulk of these trading dynamics, which of course is very difficult to do without detailed insight into a manager’s actual portfolio. It therefore comes as no surprise that attempts to replicate individual hedge fund returns have been highly unsuccessful. In fact, lacking the required transparency, one might claim that strict replication of individual hedge fund returns is highly unlikely to be ever accomplished.

What about hedge fund indices? Since it is essentially dynamic trading that makes a hedge fund, dynamic trading is crucial when replicating a single hedge fund. Its importance declines, however, when attempting the replication of a more diversified basket of hedge funds, especially when these funds follow significantly different strategies. In that case trades may (at least partially) cancel each other out. As a result, dynamic trading becomes less of an issue. It is exactly this phenomenon, which allows Merrill, Goldman and others to construct highly accurate replicas of the HFRI Composite index and similar baskets.

The HFRI Composite is a basket of over 2000 hedge funds, following a large variety of strategies. Since it is extremely diversified, the peculiarities of the various strategies will largely diversify away. The result is an index with little hedge fund-like properties left, mainly driven by equity and credit risk; just like any typical traditional portfolio.

So here is the problem. Although the HFRI Composite is advertised as a hedge fund index and calculated from hedge fund data, its returns don’t have many hedge fund-like properties at all. Replicating its returns therefore hardly qualifies as true hedge fund replication as we have defined it.

From an investment point of view, the value of these hedge fund replication products is also doubtful. They exhibit a strong correlation with the stock market, which severely limits their attraction as portfolio diversifiers. Investors that buy into these products are basically selling off equity and credit exposure to finance the investment and then buying more or less the same exposure back in a different form. By itself this wouldn’t be so bad, were it not that the new product probably costs 3 or 4 times as much as the old. This also explains why the main players are so eager to issue these products. Pour some hedge fund replication and alternative beta sauce over something old and boring and suddenly it sells again like new.

Expect to Earn the Market Return

Continuing under the assumption that hedge fund replication is indeed possible, it is sometimes suggested that we should not aim to replicate after-fee returns, but target pre-fee returns instead. Unfortunately, comments like these implicitly assume that we can somehow make something out of nothing. The risk premium on a synthetic hedge fund derives from the risk premiums on the assets and asset classes that are being traded. We therefore have to accept that, by construction, synthetic funds produce no alpha. Of course, one can always set a more ambitious target, as when going after pre-fee instead of after-fee returns, but all this will produce is a higher shortfall, not a higher expected return. Put simply, it is the market that determines the expected return on a synthetic fund, not the target that is being set. For the same reason, one cannot expect to be able to replicate the best hedge funds in the business. After fees, these funds beat the market, something synthetics can only dream of.

Synthetic Funds Are Not for Everybody

Who should invest in synthetic hedge funds? In the end, it all depends on how confident an investor is of his ability to find those truly skilled hedge fund (of funds) managers (and talk them into allowing him to invest with them). Investors who are confident they have enough skill to successfully identify those managers that will more than make up for the fees that they charge, should do so. Synthetic hedge funds are not for them. However, for those who realise how good one’s manager selection skills will need to be, to be successful, synthetic hedge funds are an alternative well worth considering.

Weak Replication and Optimal Diversification

Strict replication of hedge fund returns has proven to be an illusion and it probably always will be. So what about weak replication?  First, it is important to note that in most applications, strict replication is not required. Investors invest in hedge funds for their return properties, i.e. their low volatility, low correlation with stocks and bonds, etc. It is therefore sufficient to produce returns with these particular properties. As long as the returns generated exhibit the desired characteristics, the actual sequence in which they arrive is of no real importance for investors.
This brings us to the FundCreator approach. FundCreator is a risk management tool that allows its users to design futures trading strategies that generate returns with pre-defined statistical properties. Although not designed to replicate anything in particular, one of its uses is to design trading strategies that generate returns with properties similar to those of hedge funds or hedge fund indices. Contrary to strict replication, extensive research has confirmed that this can be done quite successfully.

With the availability of a system able to generate returns on order, the obvious question that comes up is why one would still want to replicate if we now have the power to create? Why replicate something that is obviously imperfect, if investors can create their own ideal diversifier, not necessarily available anywhere else in the market? Using FundCreator in this way, allows us to plug the diversification leak in many investors’ portfolios. Put differently, it allows us to design and create the optimal addition to a given portfolio, which solves the problem of under-diversification once and for all, easy and at minimal costs


Strict hedge fund replication is an illusion. So far, nobody has been able to replicate hedge fund returns accurately and it doesn’t seem likely that anyone will soon. The current hedge fund replication products offered by the main product providers should not be referred to as hedge fund clones as, apart from the fact that they are constructed from hedge fund data, the indices that they aim to replicate have very little hedge fund-like properties and are mainly driven by equity and credit risk, just like most traditional portfolios.

Weak replication does work. However, why would one want to replicate a specific hedge fund or index when given the opportunity to design one’s own optimal diversifier from scratch? The FundCreator technology gives investors a unique opportunity to create new tailor-made diversifiers with characteristics that are optimal given their existing portfolios. The hedge fund replication and alternative beta hype will come and go, but synthetic fund creation is here to stay.  Mark my words.

HMK, 08-08-2007

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  1. wanderer
    August 12, 2007 at 9:40 pm

    In the past week, there were many EMN funds (quant funds) that were down -20% and then recovered the entire +20% on the friday. I wonder whether the FundCreator would have even come close to modeling the behavior of the EMN returns during the extreme days …

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