Tell Me What You Want, What You Really, Really Want! An Exercise in Tailor-Made Synthetic Fund Creation

Abstract

Recently, Kat and Palaro (2005) showed how dynamic trading technology can be used to create dynamic futures trading strategies (or 'synthetic funds' as we call them), which generate returns with predefined statistical properties. In this paper we put their approach to the test. In a set of four out-of-sample tests over the period March 1995-April 2006 we show that the Kat and Palaro (2005) strategies are indeed capable of accurately generating returns with a variety of properties, including negative correlation with stocks and bonds and high positive skewness. Under difficult conditions, the synthetic funds also produce impressive average excess returns. Combined with their liquid and transparent nature, this confirms that synthetic funds are an attractive alternative to direct investment in popular alternative asset classes such as (funds of) hedge funds, commodities, etc.

Keywords: synthetic fund, dynamic trading, correlation, skewness, asset allocation

JEL Classification: G11, G13, G23