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

33.3 POTENTIAL BENEFITS OF REPLICATION PRODUCTS

Before discussing the various approaches to hedge fund replication, the potential benefits that one may receive from using a replication product must be examined. The term using is employed, rather than investing, because investors may benefit from these products even if they do not make any allocations to them, as replication products can lead to a better understanding of the underlying risks of hedge funds and allow investors to build better benchmarks against which to measure their hedge fund investments. The reason that investors may allocate to hedge funds in the first place needs to be understood. In other words, why is it of some potential value to replicate hedge funds?

As discussed in the CAIA Level I and Level II curriculum, to understand the potential benefits of investing in hedge funds, one must distinguish among various strategies. Some strategies have significant systematic risks, and therefore allow investors to earn relatively high risk-adjusted return through exposure to directional market risks. Equity long/short funds and some global macro funds fall into this category. The primary benefit that investors seek in investing in these return enhancers is to improve the risk-adjusted return of their portfolios. This benefit can come from earning alpha, or by investing in alternative beta exposures that are underweighted in the investor's traditional portfolio. The alpha is typically measured relative to the performance ...