Factor Selection in Hedge Fund Replication Dynamic Models

36 Pages Posted: 13 May 2011 Last revised: 26 May 2011

Date Written: May 11, 2011

Abstract

While the use of dynamic factor models for Hedge Fund Replication (HFR) has proven to be superior to standard OLS methodologies (e.g., Roncalli and Weisang, 2009a,b), current factor selection methodology in these dynamic settings by means of direct PCA-based estimation of the factors (e.g., Darolles and Mero, 2008) provides results having poor interpretability and small, yet significant, improvement over more naive selection methodologies. In this paper, I contend on the one hand that this type of direct factor estimation is doomed to be at best biased and unreliable in finite samples as indicated by results from random matrix theory (Harding, 2008). On the other hand, forward filtering-backward sampling (FFBS) algorithm and reversible-jump MCMC allow considering a factor selection methodology using observable instruments as potential factors hence solving both problems of identification and interpretability. I provide here a detailed algorithm and the results of its application to a simple and classic replication example.

Keywords: Tracking problem, hedge fund replication, alternative beta, Kalman filter, Factor Selection, Model Selection

JEL Classification: G11, C52

Suggested Citation

Weisang, Guillaume, Factor Selection in Hedge Fund Replication Dynamic Models (May 11, 2011). Available at SSRN: https://ssrn.com/abstract=1838622 or http://dx.doi.org/10.2139/ssrn.1838622

Guillaume Weisang (Contact Author)

affiliation not provided to SSRN

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