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Lifting the Veil: Why Hedge Fund Replication Works

Hedge funds invest in opaque and esoteric instruments that do not appear amenable to replication at first glance. The explanation resides in two parallel theoretical frameworks for investment. The first is modern portfolio theory that connects their investments and strategies to the public markets. The second is behavioral economics, which connects the strategies deployed to the universe of hedge fund managers. These frameworks provide the rationale for replication.

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Modern portfolio theory suggests that the public markets are efficient. Further, the value of a company does not come from the firm's financial structure but the provision of the goods of service they provide. The financial structure can transition the returns to one class of capital provider to another but does not change the underlying value. For example, a firm may increase leverage by issuing debt. This action results in two outcomes: higher return for the equity holders and higher risk for both capital providers.

Efficient public markets are the basis for hedge fund strategies.

The relationship to hedge funds strategies is direct. While a significant portion invests in public markets, others invest in less liquid or private markets. This latter action does not change the value of the firm. It only differs in the frequency and confidence in the valuation. Critically, most hedge funds value illiquid securities from the more robust price discovery process in the public market, and they borrow in public debt markets. They are susceptible to their public market variability, whether they invest in public or private markets because they use a comparable public market security for valuing their instruments. Thus, factor exposures are similar across public and private markets regardless of how their differing performance reporting.

Behavioral finance suggests a few commonalities that influence the replication ability. The herding mentality shows that mangers and asset flows tend towards a common strategy or type of exposure (e.g., machine learning strategies). The investor exhibits a behavioral bias by falling for the narrative fallacy by seeking a good story for the currently popular strategy. The later can lead to confirmation and overconfidence biases as asset flows into a strategy and validate the strategy. Anchoring bias suggests that managers will continue with an approach irrespective of the performance (e.g., value investing for the last decade) and leads to loss aversion. Self-attribution bias leads mangers to suggest they are the ones that delivered the good outcomes while sheer bad luck drove the poor outcomes. These biases result in common views and persistent factors exposures that enable replication for liquid alternatives.

Behavioral bias suggests common and persistent views.

A linkage exists between the common views and the modern portfolio theory. The hedge fund managers have differing opinions and allocations to a factor, which results in diversification of the strategies. The zero-sum outcome of strategies removes the unique alpha exposures in a diversified hedge fund index. The commonality is the diversified public market and strategy specific factors. With time-varying factors, the challenge is not identifying the factors. It is specifying the amount of the common factor exposure.

In a world of instantaneous pricing, the markets can evolve rapidly as new information enters. Thus, timeliness is paramount when managing factor exposures for an individual manager. At the index level, the result is different. The diversity of views provides efficiency to the market because not all managers frame the new information the same, nor do they share common starting points (i.e., one may be short and another long the same factor exposure). Further, the communication of data related to companies occurs quarterly in their financial reports. In contrast, economic data is monthly or longer. Thus, dissemination of information occurs gradually and results in persistent strategy exposures.

An Alternative Conclusion. The hedge fund universe provides a diverse array of strategies that provide alternatives to traditional asset classes. The increasing integration of the financial markets and the proliferation of hedge fund managers ensure competition for alpha. These trends are magnified by the expansion of ETFs and data science that empower more investors to access these alternate return strategies. In diverse portfolios of hedge funds, the existence of uncorrelated alpha to the major public markets is minimal. Liquid alternatives potentially offer similar risk and return profiles to hedge funds by accessing their strategy exposures at a lower cost and liquid format. Thus, liquid alternatives are a meaningful tool for investors and fiduciaries that empower them towards their strategic objective, a diversified portfolio.

The benefits of liquid alternatives are many. They improve the efficiency of a traditional portfolio and reduce the major risk factor exposures. They deliver lower costs, increased transparency, and enhanced liquidity to the investor. The demand for alternative factor exposures may increase as near-zero interest rates linger. Liquid alternatives provide a compelling argument to the investor seeking to manage their portfolio risk, liquidity, and cost.

Practicality for an investor is paramount. Liquid alternatives empower timely transition management into hedge funds, promote more tactical decisions with liquidity, and advance risk management through transparency.

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