The Myths and Limits of Passive Hedge Fund Replication

Call for ReactionFollowing recent initiatives by major investment banks such as Merrill Lynch and Goldman Sachs, EDHEC researchers have undertaken a detailed critical analysis of the various methodologies involved in hedge fund replication offers, examining the benefits and limits of the “factor-based” and “pay-off” distribution approaches. In the study, “The Myths and Limits of Passive Hedge Fund Replication,” co-written by Lionel Martellini with Noël Amenc, Walter Géhin and Jean-Christophe Meyfredi, the authors find that overall, one could only possibly hope to achieve truly satisfying results by combining the best of the two competing approaches.

On the one hand, the authors argue that standard implementation efforts of the factor-based approach, arguably the most natural and straightforward way to tackle the hedge fund replication problem, have mostly failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis. They also argue that the payoff distribution approach, on the other hand, while insightful and found to generate (relatively) satisfying results on an out-of-sample basis, unfortunately cannot be regarded as a method suitable for performing hedge fund replication, at least not in a sense likely to meet investors' expectations, due to its documented failure to match a number of relevant time-series properties of hedge fund returns.

In conclusion, hedge fund replication, while obviously a powerful and attractive concept, is still, at least in terms of successful implementation, very much a work-in-progress. EDHEC's analysis suggests that it is only through the introduction of novel adapted econometric techniques allowing for a parsimonious statistical estimation of the dynamic and/or non-linear functions relating underlying factors to hedge fund returns that hedge fund replication could be turned from an attractive concept into a workable investment solution.

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