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.

Hedge funds had a nice May, up 5.2 percent on average. While the recent market rally no doubt helped, hedge funds also appear to be benefiting from less competition (see Economist article), with approximately 1,500 funds liquidating last year. This follows a similar trend observed in the late 1990s when less competition for trading opportunities helped those funds that survived after the LTCM failure.

But as reported in the article, not everything is rosy. After poor performance in 2008, many investors are requiring a more fair fee structure, one that is either closer to 1-10 (instead of 2-20), or that phases in fees over a longer period, after the fund has outperformed a benchmark - with the benchmark closer to the general market, and not simply zero, or a non-negative return. Investors also seem to be asking for more managed accounts where they can see where their money is being invested, and can also withdraw it quicker (and without gate restrictions). If that was not challenging enough, one cannot forget the added government regulation is coming down the pike. Possibly the biggest loser will be the funds-of-funds, which tack on an extra level of fees for the expertise of picking the best funds. Their failure to outperform enough to compensate for the extra fees, along with the benefits of cheaper hedge fund replication clones (see previous posts here, here, here, and here), are also making their services less cost effective.

ETF Securities is launching an exchange for ETFs that includes a consortium of over 15 global banks and asset managers (see Hedge Fund Review article). The structure allows each exchange member to be able to participate in trading, market making, and index replication activities while allowing counterparty risk to be spread among multiple exchange members. By concentrating liquidity in a single location, ETFs that would normally be unavailable due to low demand and liquidity issues, can now be created and used for more specific purposes, such as hedge fund replication, without the same trading and credit worries. Certainly an interesting idea during a time when many are concerned about those on the other side of the transaction, especially when specialized, low liquidity securities are involved. This may be one way to help reduce both counterparty and liquidity risk for those researching and implementing hedge fund replication products.

A recent Financial Times article highlights that 15 percent of asset management houses, pension funds, and private banks have invested in hedge fund replication strategies (the survey had only 97 respondents). Given the low number of companies offering products, the interest and use indicates that some firms are engaged in internal model development. As further encouragement for the field, 55 percent say they would be willing to consider investing in replication strategies, while only 30 percent were against such investment (of course, that could change as the strategies become more developed). On the down side, a significant minority of respondents also felt that hedge fund returns could not be replicated, were not transparent enough, used unproved technology, or simply gave poor returns. Many appear to be waiting for better products, even though there is a significant fee reduction when using replication strategies. Considering that the hedge fund industry is currently unpopular and an easy punching bag, not to mention being down for the year, the results are encouraging for those doing replication research and indicate some interest for the development of more robust models going forward.

There was an interesting article at the AllAboutAlpha blog a few weeks ago that discusses a recent working paper that considers a new method for measuring the systematic risk to the financial system that results from the level of hedge fund leverage. The report considers both funding leverage and instrument leverage (i.e., leverage to increase returns directly, such as buying on margin, compared to leverage that results from the product itself, such as buying an option contract). Of interest is that the study uses techniques from hedge fund replication research in order to determine the level of leverage a fund was using. Fascinating stuff for someone interested in developing hedge fund replication models. Nonetheless, given the recent issues with marketing to model when data is limited, the models developed will no doubt need to be improved a little before the Bank for International Settlements incorporates it into the next version of the Basel accord.

Recently, there have been some interesting financial products being released and/or discussed (see previous posts, here and here). Now IndexUniverse.com is discussing the development of a no-load, open-ended mutual fund that is based on hedge fund replication techniques. The fund offered by IndexIQ, called the IQ Alpha Hedge Strategy Fund, replicates hedge funds returns by purchasing various combinations of individual securities and ETFs, ETNs, and ETVs. The fund does not come cheap since investors in the replication fund will need to pay both the management fees from the replication fund, along with the operating expenses of the underlying securities and exchanged traded products that are used for replication. As of June 4, 2008, the index was comprised of 13 ETFs, ETNs, and ETVs representing exchanged-listed securities, fixed income, currencies, commodities, and real estate assets. This will bring the total expenses of the fund to 1.64% for investor class shares, slightly below the 2% expense ratios often required by traditional hedge funds. The advantage is that unlike traditional hedge funds, replication strategies can save the investors the 20% fee on profits that is also typical for hedge funds.

The IQ Alpha Hedge Index uses algorithms to create six strategies that seek to replicate the risk-adjusted returns of six different hedge fund indexes, including Long/Short Equity (currently -16.67%), Equity Market Neutral (13.33%), Fixed Income Arbitrage (3.33%), Global Macro (33.33%), Emerging Markets (33.33%), and Event Driven (33.33%). Then, optimization techniques and leverage are used to generated alpha by adjusting the weights among these six hedge fund strategies. In addition to adjusting for return, adjustments are also made to provide lower volatility relative to the S&P 500, with a correlation to the S&P 500 that is similar to the correlation between typical hedge funds and the index. The fund, which has been offered for only a short time, currently has an alpha of 7.72%, beta of 0.48%, and correlation of 0.58 versus the S&P 500. More details about the fund can be found in their fund summary sheet. It is also worth mentioning that a number of researchers, investors, and hedge fund managers do not necessarily believe that replication funds are as fantastic as often advertised. A somewhat dated, albeit still interesting and different perspective can be found in a post at the Hedge Fund blog.