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

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:

• Choice of benchmark. The benchmark to be replicated must be selected carefully. The most common practice is to use a publicly available index, such as one of the HFR or Center for International Securities and Derivatives Markets (CISDM) strategy indices. It is also possible to create a custom-made benchmark that meets certain criteria. If a strategy index (e.g., equity long/short) is used as a benchmark, the investor may want to ensure that only those managers that clearly follow such a strategy are added to the benchmark, rather than relying on the self-declared strategy of managers. Hedge fund indices are investable or noninvestable. Tracking products have a much better fit with investable hedge fund indices, ...