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Hedge fund replication

Research paper by John Grummitt, Steve Satchell

Indexed on: 07 Jul '11Published on: 07 Jul '11Published in: Journal of Derivatives & Hedge Funds



Abstract

In this article, we look at hedge fund replicators. These are products sold by financial institutions, which aim to match the returns of hedge funds. Hedge funds are able to make a positive return even in falling markets; however, they charge high fees and often require investors to maintain their investment in the fund for a certain minimum period. Hence, having a liquid replicator fund with low fees and the same returns as the hedge fund may be a preferable investment to holding the hedge funds themselves. We look at the some of the hedge fund replicators which have been proposed in the literature, focusing on the replicator proposed by Hasanhodzic and Lo in their 2006 paper, we repeat their analysis for the more volatile period of the previous few years. We find a reasonable match between the replicator and the Dow CSFB index of self-reporting hedge funds. The replication is not perfect which could be due to problems in the replicator or that the index rulebook does not fully capture the hedge fund market. Using the published index construction methodology and a C++ simulation of a hedge fund market, we find some evidence that the difference could be explained by the index rules failing to capture all of the aspects at play in the hedge fund sector. Continuing our analysis, we investigate whether true hedge fund returns are closer to the returns of the replicator than the index of reported returns. We seek to explain why a difference exists between the two by proposing a model in which hedge fund managers ‘benchmark’ themselves against some expected return and look at the probability of them not reporting returns if they fail to meet these expectations. We then try to discern possible candidates for this benchmark. Using this model, we find evidence consistent with the hypothesis that hedge fund managers are selectively reporting in order to present their returns in a more favourable light. The model suggests that if hedge fund managers are selectively reporting returns, one in 20 hedge fund managers would not report a monthly underperformance of 1 per cent.