Alternative Beta Strategies and Hedge Fund Replication

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Breaking the Black Box

This is a handbook for replicating the returns of hedge funds at considerably lower cost. Once thought to be impossible, hedge fund replication is fast becoming a buzzword in the finance community – driven by the growing realization that most hedge fund returns come from risk premiums rather than manager alpha. Not since the emergence of index funds have so many people gotten active about being ‘passive’!

However, the term ‘hedge fund replication’, while catching the imagination of investors and product providers, is also a source of confusion. What is it that we want to replicate: the past time series properties of past hedge fund returns, the distributional properties of the past hedge fund performance, or maybe the economic sources of hedge fund returns? This book will shed some light on this legitimate question.

Because replication means modeling beta-driven returns, it requires a thorough understanding of hedge return sources and their associated risks. So I will pave the way for replication by first reviewing what hedge funds really are (and aren't), and explaining the return sources of common strategies. By opening the black box of hedge funds, I also hope to dispel two conflicting but popular misconceptions. Hedge funds as a class are neither magic money machines nor scams but simply innovative investment vehicles whose characteristics can, in most cases, be understood, analyzed, modeled, and duplicated. I hope to help you do just that.

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