CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

33.1 INTRODUCTION

This chapter discusses hedge fund replication methodologies and potential applications of products developed using these methodologies. The subject of hedge fund replication was first examined by academics in the early 2000s while attempting to develop performance benchmarks for hedge funds. Later, in 2007, following initiatives by major investment banks (such as Merrill Lynch, Goldman Sachs, Credit Suisse, and Morgan Stanley) and other firms to introduce investable hedge fund replication products, there was renewed interest in the subject among academics and practitioners.

This chapter examines, from both a theoretical and an empirical standpoint, the respective benefits and limits of the three different approaches to hedge fund replication, which are referred to as factor-based replication, payoff-distribution replication, and bottom-up replication (also called algorithmic replication). The chapter examines the potential benefits that replication products could offer investors, and provides a brief summary of some of the empirical evidence regarding the performance of these products.