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Alternative Beta Strategies and Hedge Fund Replication by Lars Jaeger

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10

Replication and the Futureof Hedge Funds

10.1 BEYOND ALPHA

Replication is only possible because beta predominates. Most hedge fund returns derive from risk premia rather than market inefficiencies. Surprisingly, this is actually good news for the industry. Because inefficiencies disappear as they are exploited, it is unlikely that there will be enough remaining inefficiencies in the market to indefinitely support the growth of hedge funds. On the other hand, the opportunities to develop new ways to identify and earn risk premia are almost unlimited. But both investors and fund managers must understand the difference.

The state of hedge fund research in the early twenty-first century is analogous to physics at the beginning of the twentieth. We have begun to understand the ‘atoms’ of hedge fund returns, their return sources. These in turn are being broken down into their elementary particles: beta, alpha, epsilon (the random term – in other words, luck). What we now observe is the emergence of an underlying fundamental theory for hedge fund returns. To stretch the physics analogy a bit further, what is emerging is a theory of ‘quantum mechanics’ for hedge funds. The hedge fund risk premia are more clearly revealed from behind the clouds of alpha. Applying this new understanding to the real world of investing can have effects as revolutionary as applying quantum mechanics did to the worlds of chemistry and industrial technology.

10.2 WHAT DO INVESTORS SAY SO FAR?

Even at this ...

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