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Can Hedge-Fund Returns Be Replicated?: The Linear Case

Jasmina Hasanhodzic

Babson College - Finance Division

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

August 16, 2006

Hedge funds are often cited as attractive investments because of their diversification benefits and distinctive risk profiles - in contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or clones using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we find that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge

Number of Pages in PDF File: 54

Keywords: hedge funds, investments, portfolio management, risk management

JEL Classification: G11, G12, G13, G24

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Date posted: August 27, 2006  

Suggested Citation

Hasanhodzic, Jasmina and Lo, Andrew W., Can Hedge-Fund Returns Be Replicated?: The Linear Case (August 16, 2006). Available at SSRN: http://ssrn.com/abstract=924565 or http://dx.doi.org/10.2139/ssrn.924565

Contact Information

Jasmina Hasanhodzic
Babson College - Finance Division ( email )
Babson Park, MA 02457-0310
United States
Andrew W. Lo (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
100 Main Street
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)
HOME PAGE: http://web.mit.edu/alo/www
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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