33.6 FACTOR-BASED APPROACH TO REPLICATION
As discussed in the first section, there are three broad approaches to hedge fund replication: (1) factor-based, (2) payoff distribution, and (3) bottom-up or algorithmic.
The underlying assumption behind the factor-based approach is that a significant portion of a fund's returns can be explained by a set of asset-based factors. This approach involves construction of a portfolio, composed of long and/or short positions in a set of suitably selected risk factors that minimizes the tracking error with respect to the predefined benchmark being replicated. The benchmark may consist of a single manager or, more commonly, an equally weighted hedge fund index. The following issues must be addressed in constructing a replication product: