Why It’s ‘Too Early’ to Give Up on Replicating Hedge Funds

Liquid alternatives have so far underperformed hedge funds. That might be changing.

Illustration by II

Illustration by II

Can investors get hedge-fund-like returns in liquid strategies? So far, the real-life results have been mixed — but a trio of academic researchers say it’s too soon to give up on hedge fund replication.

Researchers at the National University of Singapore found that market risk exposures, including stock market beta and investment factors like value and momentum, can explain up to 81 percent of North American and Asian hedge fund returns. The finding is in line with past research that has attributed portions of hedge fund performance to identifiable risk factors.

“The critical question that arises is whether hedge fund returns can indeed be replicated with public market instruments that mimic conventional sources of risk premia,” wrote authors Joseph Cherian, Christine Kon, and Ziyun Li.

Existing liquid alternative strategies have generally underperformed hedge funds. A 2019 study in the Journal of Alternative Investments found that hedge funds beat liquid alternative mutual funds by an average of 1 percent to 2 percent per year, even after accounting for hedge funds’ higher fees.

More recently, some liquid alternative strategies struggled during the Covid-19 market downturn due to their high equity market exposures. In one example noted in the National University of Singapore study, JPMorgan Chase & Co, — “one of the earliest to come up with liquid alternatives as a financial product” — shut down four hedge-fund-replicating exchange-traded funds in May.


“It is therefore propitious timing to reanalyze the alpha, risk factor exposures, and performance of hedge fund strategies,” Cherian and his co-authors wrote.

For the study, the trio examined the performance of North American and Asian hedge fund index strategies between January 2000 and March 2020, using Eurekahedge’s hedge fund indices. Performance was evaluated using ten market exposures, including stock index returns, currency prices, and the Fama-French risk factors.

They found that correlation to these market risks were “generally high,” accounting for at least half of performance in most hedge fund strategies. The highest correlations were found in the long/short strategies indices, with Asian long-short hedge funds “significantly exposed” to the size factor and stock market beta, while North American long-short funds were closely linked to value and commodity exposures.

Meanwhile, macro and managed futures strategies had low and — in the case of North American macro hedge funds and Asian managed futures funds — almost nonexistent correlations to the basket of market exposures.

“Macro and managed futures indeed demonstrate market neutrality on average, and variation in returns cannot be explained by exposure to risk factors, at least over the 20-year period,” the authors wrote.

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For the other strategies, however, the authors found that they could use the risk factor exposures to create “clones” that closely replicate hedge fund exposures. These clones underperformed hedge fund indices during the analyzed period from January 2005 to March 2020, which the researchers attributed to poor performance before and during the 2008 financial crisis. After the crisis, however, they found that clones “caught up” to the actual hedge funds, delivering results that were “almost on par.”

Moreover, they found that their cloned strategies largely outperformed during the more recent Covid-19 crash. According to the study, this reversal may be due to a “drastic” decline in hedge fund alpha following the 2008 financial crisis.

There are a few caveats to the findings: The study does not include replication costs and tracking error, and the returns are also gross-of-fees. Still, the authors said their results pointed to the potential for successful hedge fund replication.

“Synthetic hedge fund clones are popular due to their lower fees and higher transparency, but doubts remain as to whether they are sustainable,” the authors concluded. “Our results… indicate it might be too early to dismiss hedge fund replication strategies.”