Hedge Fund Replication is a viable alternative to direct investments in hedge funds.

What do we know? Hedge funds can provide better risk-adjusted returns.

Many institutional investors use hedge funds (HF) as a diversification tool in order to improve the overall risk profile of their existing portfolios. The analysis is often focused on a reduction in correlation against major indexes and a reduction in the volatility of the portfolio. (Haglund, 2010) Amin and Kat have investigated the diversification effects that occur when combining HF with stocks and bonds. They show that HF do not mix too well with equity and that including HF in a traditional investment portfolio not only improve portfolios meanvariance characteristics, but also lead to significantly lower skewness as well as higher kurtosis. (Amin & Kat, 2002)

FOHF is preferred over HF by institutional investors.

FoHF (claim to) take care of the many unavoidable, time consuming and complex issues that come with investing in a highly opaque asset class such as hedge funds. (Ryan, Harry, & Sa, 2009).

Fund of Hedge Funds (FOHF) have a high fee structure.

Brown, Goetzmann, and Liang, (Brown, Goetzmann, & Laing, 2004), however, find that the diversification, oversight, and access come at the cost of a multiplication of the fees paid by the investor. They discover that individual hedge funds dominate funds of hedge funds on an afterfee return or on a Sharpe ratio basis. Hence, the information advantage of funds of hedge funds does not compensate investors for the fees. The same conclusion is found in Amin and Kat where the average stand-alone fund of hedge funds efficiency loss exceeds that of the average non-fund of funds hedge fund index by 5.17%. (Amin & Kat, 2003).

Why hedge fund replication?

Driven by a desire to reduce costs and improve investor returns, as well as to avoid the many other drawbacks surrounding hedge fund investment, such as llliquidity and lack of transparency, the market has recently seen several attempts to "replicate" hedge fund index returns. These have received quite some attention in the media and among practitioners. Put simply, hedge fund return replication is about generating hedge fund-like returns by mechanically trading traditional asset classes. The driving force behind hedge fund replication is the realization that the majority of hedge fund (of funds) managers do not have enough skill to make up for the fees that they charge. (Kat, 2007) There are different types of Hedge Fund return replication strategies available today. In a nutshell, these initiatives are meant to enable investors to achieve returns similar to hedge funds' returns with significantly lower fees through investment in a set of rules-based strategies based on liquid underlying assets aimed at replicating hedge fund performance, or at least the systematic factor exposure in hedge fund returns, i.e., their (traditional and alternative) beta components, as opposed to their alpha components. (Amenc, Gehin, Martellini, & Meyfredi, 2008) FACTOR REPLICATION APPROACH The factor replication approach involves looking for 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 individual hedge fund, or hedge fund index, to be replicated. The best mimicking portfolio estimated from the n-sample analysis is then passively held in the out-of-sample period, and out-of-sample performance is recorded and compared to the performance of the

hedge fund target.

PAYOFF DISTRIBUTION APPROACH The payoff distribution replication approach has been developed by Amin and Kat [2003] but finds its roots in the seminal work of Dybvig [1988]. The principle of payoff replication is very simple and inspired from derivative pricing theory. It is based on the following two-step process. The first step consists of estimating the payoff function g^ that maps an index return onto a hedge fund return, while the second step consists of pricing the payoff and deriving the replicating strategy, in accordance with the Merton [1973] replicating portfolio interpretation of the Black and Scholes (1973) formula. (Amenc, Gehin, Martellini, & Meyfredi, 2008)

What do we not know?

Empirical findings suggest that hedge funds can be cloned i.e. there return characteristics can be replicated. However the differences in performance of clones across hedge-fund categories raises an important philosophical issue. What is the source of the clones' value-added? One possible interpretation is that the cloning process reverse-engineers" a hedge fund's proprietary trading strategy, thereby profiting from the fund's intellectual property. Two assumptions underlie this interpretation, both of which are rather unlikely: (1) it is possible to reverse-engineer a hedge fund's strategy using a linear regression of its monthly returns on a small number of market-index returns; and (2) all hedge funds possess intellectual property worth reverse-engineering.

By analyzing the monthly returns of a large cross-section of hedge funds it is possible to identify common risk factors from which those funds earn part, but not necessarily all, of their expected returns. By taking similar risk exposures, it should be possible to earn similar risk premia from those exposures, hence at least part of the hedge funds' expected returns can be attained. Despite the promising properties of linear clones in several style categories, it is well known that certain hedge-fund strategies contain inherent nonlinearities that cannot be captured by linear models. Therefore, more sophisticated nonlinear methods may yield significant benefits in terms of performance and goodness-of-fit. However, there is an important trade-off between the goodness-of-fit and complexity of the replication process, and this trade-off varies from one investor to the next. As more sophisticated replication methods are used, the resulting clone becomes less passive, requiring more trading and risk-management expertise, and eventually becoming as dynamic and complex as the hedge-fund strategy itself. While the replication of hedge fund factor risk exposures appears to be a very attractive concept from a conceptual standpoint, one has to conclude that it still is very much a work in progress. Given what we do not know, what issue should be addressed? What research can be conducted to fill in the gap in our knowledge? Your studys variables The type of your research study Reference section