Hedge Fund Replication

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Hedge Fund Replication

• Hossein Kazemi
• CISDM
• White Bear Partners, LLC
• kazemi_at_som.umass.edu
• November 16, 2007

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Alphas and Betas of Hedge Funds

• Hedge funds are marketed as absolute return
  investment products.
• Most of the returns are supposed to come from
  idiosyncratic bets made by managers
• Systematic components of returns are supposed to
  be small.
• Evidence provided by academic research during the
  last decade shows otherwise
• Diversified portfolios of hedge funds have
  significant exposures to various factors
• The exposures are in some instances different
  from those provided by traditional asset classes
• A significant portion of returns is due to
  exposures to these sources of risk-return

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Betas and Alphas of Hedge Funds
Dominant Paradigm 1960-2000
Emerging Paradigm 2000-Present
Traditional Assets
Alternative Assets
Traditional Assets
Alternative Assets
Beta Return
Beta Return
Beta Return
Beta Return
Alpha Return
Total Return
Alpha Return
Alpha Return
Alpha Return

• Academic research has helped change the dominant
  paradigm that hedge funds are pure absolute
  return investment products

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Summary of expected exposure for HF Styles
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Common Sensitivities To Market Factors
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Evidence on the Alternative Betas Hedge Equity
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Evidence on the Alternative Betas Fund of Funds
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Alternative Betas Alphas

• Alternative betas have come to represent
  systematic exposures of hedge fund strategies to
  accessible sources of beta returns.
• Hedge fund replication products attempt to
  replicate returns attributed to alternative
  betas.
• Replication products are not meant to replicate
  the alpha of hedge funds (if there is any).

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Alternative Betas Alphas

• Alternative betas are not constant and
  replicating strategies attempt to capture
  dynamics of these betas.
• Recent increase in hedge funds beta is not a
  disturbing fact because markets have been rising
  in recent years. Will the betas decline when
  markets begin to decline?
• Graph on the next page shows that hedged equity
  managers reduced their betas as SP500 declined
  during 2000-2002, and increased their betas in
  2003 as markets began to recover.

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Changing Betas of Hedge Funds
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Benefits Replication Strategies

• WBP replication strategies provide the following
  benefits
• Liquidity without adverse performance impact
  Most liquid securities are employed.
• Immediate diversification ETFs, futures
  contracts and other diversified assets are used.
• Transparency of the product The algorithm is
  completely self-contained and transparent.
• Results Low startup (due diligence) cost. No
  illiquidity cost. No style drift.

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Applications of Replication Strategies

• Long-term investment tactical asset allocation
  Because of its liquidity, the product could be
  used in a TAA program.
• Hedging of existing positions Because the
  product can be shorted, it can be used to hedge
  illiquid long positions in certain hedge fund
  strategies.
• Cash management Because of its liquidity, the
  product can be used to manage cash.
• ETF Creation The product could be used to create
  an Exchange Traded Fund.

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Approaches to Replication

• Factor Replication A portfolio of liquid assets
  is created to track the time-series properties of
  a target hedge fund index.
• Between 30-90 of time series variations of
  hedge funds can be explained by the replicating
  portfolio.
• Replicating portfolios have negative annual
  alphas between 15-100 bps.
• Moment Matching Dynamic hedging approach is
  employed to match the return distribution of a
  given target. The correlation between the target
  and the portfolio could be very small.

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Performance Comparison (Beware of Pro Forma Pre
07)
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Performance Comparison (Beware of Pro Forma Pre
07)
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Live Return of WBP, LLC