Alternative Beta Strategies and Hedge Fund Replication

2

What Are Hedge Funds, Where DidThey Come From, and Where AreThey Going?

In order to elaborate on hedge fund return sources and replication techniques, we will first need to define what a hedge fund is and give a brief overview of the universe of hedge fund strategies. This chapter will give the reader the necessary background on hedge funds, including an understanding of where this industry came from and where it stands today. As it happens, defining what constitutes a hedge fund is quite tricky.¹ Nevertheless, before plunging into the discussion of hedge fund return sources and hedge fund replication, we must define the hedge fund universe, discuss some basic characteristics and developments of the industry (this chapter), and describe the individual strategies together with their empirical risk and return characteristics (next two chapters). Only then can we make sense of the details in later chapters. The advanced reader might want to progress to Chapter 5 right away (but may find interesting bits and pieces in this and the next two chapters).

2.1 CHARACTERISTICS OF HEDGE FUNDS

The term ‘hedge fund’ denotes a very heterogeneous collection of different investment strategies. The confusion many people have around hedge funds starts with the lack of any precise formal or legal definition of the term. What makes a hedge fund different from other types of investment? In the world of animals, the term ‘guinea pig’ describes a popular pet that is not from Guinea, and is not a pig. ...