In Search of Missing Risk Factors: Hedge Fund Return Replication with ETFs

Abstract

We develop a new factor selection methodology of spanning the space of hedge fund risk factors with all available exchange traded funds (ETFs). We demonstrate the efficacy of the methodology with out-of-sample hedge fund return replication, and find that the replication accuracy increases with the number of ETFs available. This is consistent with our interpretation of ETF returns as proxies to alternative risk factors driving hedge fund returns. We further consider portfolios of “cloneable” and “non-cloneable” hedge funds, defined as top and bottom in-sample R2 matches, and demonstrate that our ETF clone portfolios slightly outperform “cloneable” hedge funds out-of-sample.

Keywords: hedge funds, risk factor exposures, factor selection, return replication, performance measurement, performance prediction

JEL Classification: G11, G23