Understanding Hedge Fund Replication

By Salvatore Bruno via Iris.xyz

There are many kinds of hedge fund strategies in the market. HFR, a leading hedge fund industry research group, tracks four major categories – Macro, Equity Hedge, Event Driven, and Relative Value – each with multiple sub-strategies focused on everything from stocks and bonds to emerging markets and credit arbitrage. And, of course, every fund manager will execute these strategies differently based on his or her own research and views of the market.

Regardless of the style of strategy or manager, the goal of a hedge fund is to, over time, deliver value, either in the form of excess return over the broad market, or in downside participation, or both. But traditional hedge fund investing is an expensive process, with a significant portion of returns lost to high fees. It exposes investors to a number of unknowns, including idiosyncratic manager risk – a concentrated bet that a single manager or group of managers will outperform the market. It’s illiquid. And, of course, it’s opaque – no hedge fund manager wants to fully reveal his or her investment process over concern they will lose their “edge.”

This is where hedge fund replication strategies come in. ETFs using replication seek to identify the key characteristics that drive performance and “replicate” them in a low-cost index-based fund. This approach is supported by a body of research that has generally found that systematic exposures to traditional and non-traditional asset classes is the broadest source of hedge fund returns, supplemented in some (but by no means all) cases by manager skill. The systematic component can be referred to as “beta” (where manager skill is “alpha”) and it’s that beta that most replication strategies seek to capture in a generally liquid, transparent, and low-cost way.

For example, a Long/Short Equity manager may own a group of securities long while simultaneously shorting a different group of securities. When you aggregate all of the holdings across multiple Long/Short Equity managers, you find that many of the “stock specific” effects diversify away (much like they do when you have a large group of stocks). You are left with a bunch of “factor” returns such as Large Cap equity vs. Small Cap equity, Value vs. Growth, US equity vs. International equity, etc. Managers trying to generate alpha may, by contrast, make more concentrated positions in an effort to outperform.

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