CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

33.2 AN OVERVIEW OF REPLICATION PRODUCTS

Fundamentally, hedge fund replication products (also called clones or trackers) are created to capture the traditional and alternative betas underlying the expected return and risk of a hedge fund benchmark. Alternative betas refer to those sources of return that are not normally available through investments in traditional assets or, if they are available, are commonly bundled with other risks. For instance, publicly traded equities have exposures to a number of factors, including volatility and commodity price risks. These last two risks are generally considered as alternative sources of risk but, in the case of common stocks, are bundled with pure equity risk, which dominates the behavior of common stocks. Other examples of alternative betas are risks associated with currency investments, momentum or trend-following strategies, and structured products.

Available replication products are based on statistical techniques (e.g., factor-based and payoff-distribution approaches) or bottom-up (algorithmic) trading models. The latter approach attempts to trade the underlying securities in a manner consistent with the trading approach taken by most active managers within a particular strategy. To the degree that tracker products are designed to track active manager-based benchmarks, they are designed to capture a significant portion of the common strategy return of fund strategies, and to reflect fund managers' common beta exposures to various ...