Active Factor Investing: Hedge Funds vs. the Rest of Us

Abstract

We argue that only hedge funds whose returns are driven by beta management of exposures to latent risk factors could be successfully replicated. We develop a methodology for creating a portfolio of ETFs that replicates risk factor exposures taken by successful beta active cloneable hedge funds. The methodology allows any investor to access active factor strategies employed by hedge funds. It could be interpreted as cloning beta exposures of the best beta active hedge funds, delivering outstanding long-term risk-adjusted performance. The active factor ETF portfolio only requires annual rebalancing, and is constructed with a transparent algorithmic approach, which conforms to a definition of a smart beta strategy.

Keywords: hedge funds, risk factor exposures, factor investing, return replication, performance prediction, beta active management, smart beta

JEL Classification: G11, G23