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Hedge Fund Replication

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Betas and Alphas of Hedge Funds ... Alternative Betas & Alphas ... Replicating portfolios have negative annual alphas between 15-100 bps. ... – PowerPoint PPT presentation

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Title: Hedge Fund Replication


1
Hedge Fund Replication
  • Hossein Kazemi
  • CISDM
  • White Bear Partners, LLC
  • kazemi_at_som.umass.edu
  • November 16, 2007

2
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

3
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

4
Summary of expected exposure for HF Styles
5
Common Sensitivities To Market Factors
6
Evidence on the Alternative Betas Hedge Equity
7
Evidence on the Alternative Betas Fund of Funds
8
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).

9
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.

10
Changing Betas of Hedge Funds
11
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.

12
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.

13
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.

14
Performance Comparison (Beware of Pro Forma Pre
07)
15
Performance Comparison (Beware of Pro Forma Pre
07)
16
Live Return of WBP, LLC
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