Insight—Distributional Hedge Fund Replication via State Contingent Stochastic Dominance

Abstract

The topic of hedge fund replication is well established, both in the academic world, with a growing list of literature, as well as in applications with an active market for replication—and alternative beta products. Its theoretical concepts were translated into market applications early on, generating wide interest among investors, even though the resulting products did not always perform to expectations. In Section 6.2 we comment on the evolution of hedge fund replication, including a view as to the role that replication techniques can play in applications in the future: not constructing simple clones, but improving them on specific performance characteristics. Section 6.3 describes the role of hedge fund replication, and in Section 6.4 we give brief descriptions of previous replication techniques. In Section 6.5 we highlight some of the pitfalls of common replication techniques. Section 6.6 introduces a hybrid replication technique, combining the intuitive portfolio construction of factor-based replication with the less ambitious goal of replicating certain preferred and state-contingent characteristics of the return distribution rather than replicating the performance path. This approach is specifically geared to accommodate the role of replicating the good—and improving on the bad—performance aspects of a given hedge fund target. In Section 6.7 we give an empirical application of the proposed replication technique and compare it to factor-based regression, the most common replication technique thus far.