Hedge Fund Replication: A Model Combination Approach

Abstract

Recent years have seen increased demand from institutional investors for passive replication products that track the performance of hedge fund strategies using liquid investable assets such as futures contracts. In practice, linear replication methods suffer from poor tracking performance and high turnover. We propose a model combination approach to index replication that pools information from a diverse set of pre-specified factor models. Compared to existing methods, the pooled clone strategies yield consistently lower tracking errors, generate less severe portfolio drawdowns, and require substantially smaller trading volume. The pooled hedge fund clones also provide economic benefits in a portfolio allocation context.

Keywords: Hedge funds, Model pooling, Model combination, Hedge fund replication, Log score

JEL Classification: C11, C51, C53, C58, G17