Dr. Andrew Lo , MIT Professor and founder of Alpha Simplex, was recently on CNBC's Fast Money program discussing hedge fund replication using a combination of exchange traded futures and currency forwards.

Source: CNBC Video
In essence, hedge fund replication attempts to mimic the betas and returns of either individual hedge fund strategies, or the entire hedge fund industry, using common and liquid exchange traded assets, such as futures, forwards, swaps, and even ETFs. In using such assets to replicate returns, is it hoped that one can not only replicate betas and returns, but do so with comparable or less risk, and of course, less cost that a traditional hedge fund.

The specific fund that Dr. Lo helps manage, along with Jeremiah Chafkin and Robert Rickard, is a long/short replication mutual fund named the Natixis ASG Global Alternatives A (GAFAX) fund. The fund is relatively new, with an inception date of September 30, 2008, and has an expense ratio of 1.64% and an initial sales fee of 5.75% - not cheap, but less than your typical 2/20 hedge fund fee structure for longer holding periods. Year to date the GAFAX fund is up only 4.86% compared to a positive 8.74% return for the S&P 500. Nonetheless, the diversification effects of the fund have helped its returns be relatively flat since inception, compared to roughly a 20% loss in the S&P 500 over the same period. Given that the fund is less than one year old, extensive risk-return data is not yet available.

While replication strategies can attempt to replicate either single or multiple strategies, the GAFAX fund is broad-based in that it does not try to mimic one specific type of hedge fund strategy, but instead tries to get the beta and return of the diversified exposure of the entire hedge fund industry. Therefore, such a fund will not report returns that match the top outperforming funds each year, but will also hopefully avoid significant exposure to strategies that may have recently blow-up due to current market or macroeconmic factors. Furthermore, even though the fund is using reported past return data to develop its replication, the lag in performance is not expected to be as dramatic since the fund is modeling more broad-based returns, and once again is not subject to the investment changes of one hedge fund or strategy.

Hedge fund replication has been an active area of research for a number of years, both in academia and industry. It will certainly be interesting to see how such techniques perform outside the labs of academia and closed doors of industry, and whether or not such investment strategies catch on with the retail investing public. If you are looking to learn more about the field of hedge fund replication, there are a number of places to start. First, check out Dr. Lo's MIT homepage and Laboratory for Financial Engineering website were you can download some recent abstracts, publications, and working papers on hedge funds. Second, check out the wonderful blog AllAboutAlpha.com and its various articles on alternative beta and hedge fund replication strategies. The following academic papers - available on the Internet (there are others as well) - will also given you an idea of a few hedge fund replication research approaches and modeling techniques.

Can Hedge-Fund Returns Be Replicated?: The Linear Case, Hasanhodzic and Lo
Alternative Routes to Hedge Fund Return Replication: Extended Version, Harry Kat

A few books on the subject include the following:

Hedge Funds: An Analytic Perspective, Andrew Lo (includes a chapter on replication, content from his papers)
Alternative Beta Stategies and Hedge Fund Replication, Lars Jaeger

Once again, these are just a few resources available on the Internet or at your local bookstore. As mentioned, the field has been active over the last few years, and subsequently has produced a number of good articles, books, and online resources. Enjoy.

Andrew Lo, the director of the MIT Laboratory for Financial Engineering, and founder of the AlphaSimplex hedge fund, believes the next big meltdown will be in commercial mortgages (see Reuters article). While many traders and investors have been predicting that the CMBS market would be the next one to take a hit after blowups in the residential market, Lo is predicting that the losses will accelerate later this year as rates begin to be reset higher. Also of note is how Lo believes that it will be pension funds, and not the banks, that will be hurt the most when commercial real estate comes under additional pressure. In an effort to increase yield when the markets were more static, pension funds loaded up on CMBS in the years before the market meltdown. There is an expectation that many pension funds will now have a difficult time meeting liabilities, forcing the government to once again step-in with some type of bailout. While this is certainly not good news for the economy if the commercial real estate market was to play out as predicted by Lo, given the hits commercial real estate has already taken, the pressure pension funds are already under, and the number of bailouts which have already occurred, it is difficult to know - even in general terms - what the reaction and impact on the markets will be. Maybe this is the saddest realization of all.