Can Hedge-Fund Returns Be Replicated?: The Linear Case

Journal of Investment Management, Vol. 5, No. 2, Second Quarter 2007

Posted: 30 May 2007  

Jasmina Hasanhodzic

Babson College - Finance Division

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

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Abstract

In contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield additional and complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or clones using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we and that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds.

Keywords: Hedge fund, portfolio management, risk management

Suggested Citation

Hasanhodzic, Jasmina and Lo, Andrew W., Can Hedge-Fund Returns Be Replicated?: The Linear Case. Journal of Investment Management, Vol. 5, No. 2, Second Quarter 2007. Available at SSRN: https://ssrn.com/abstract=989605

Jasmina Hasanhodzic (Contact Author)

Babson College - Finance Division ( email )

Babson Park, MA 02457-0310
United States

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)

HOME PAGE: http://web.mit.edu/alo/www

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Stata Center
Cambridge, MA 02142
United States

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