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Seminars & Groups

The Myths and Limits of Hedge Fund Replication

Date: 10-15-2007
Start Time: 6:00pm
End Time: 7:30pm
Speaker: Lionel Martellini, EDHEC
Location: 412 Schapiro CEPSR, Davis Auditorium

ABSTRACT

In this paper we provide a detailed critical analysis of various methodologies involved in the so-called "passive replication" of hedge fund returns, a subject that has enjoyed renewed interest following recent initiatives by major investment banks. In particular, we examine from a theoretical and an empirical standpoints the benefits and limits of the two different and somewhat competing approaches to hedge fund replication, respectively known as "factor-based replication", and "payoff distribution replication". On the one hand, we argue that standard implementation versions of the factor-based approach, arguably the most natural and straightforward way to tackle the hedge fund replication problem, have mostly failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis. We also argue that the payoff distribution approach, on the other hand, while insightful and found to generate (relatively) satisfying results on an out-of-sample basis, unfortunately cannot be regarded as a method suitable for performing hedge fund replication, at least not in a sense likely to meet investors' expectations, because of its documented failure to match a number of relevant time-series properties of hedge fund returns. In conclusion, it appears that hedge fund replication, obviously a powerful and attractive concept, is still very much a work in progress in terms of success of implementation. Our analysis suggests that it is only through the introduction of novel adapted econometric techniques allowing for a parsimonious statistical estimation of the dynamic and/or non-linear functions relating underlying factors to hedge fund returns that hedge fund replication could be turned from an attractive concept into a workable investment solution, and we discuss several possible interesting directions for future research.

BIO

Lionel Martellini is a Professor of Finance at EDHEC Graduate School of Business and the Scientific Director of Edhec Risk and Asset Management Research Center. A former member of the faculty at the Marshall School of Business, University of Southern California, he holds Master’s Degrees in Business Administration, Economics, Statistics and Mathematics, as well as a PhD in Finance from the Haas School of Business, University of California at Berkeley.
Dr. Martellini is a member of the editorial board of The Journal of Portfolio Management and The Journal of Alternative Investments. He conducts active research in quantitative asset management and derivatives valuation, which has been published in leading academic and practitioner journals and has been featured in major European and global dailies such as The Financial Times and The Wall Street Journal. He has co-authored reference textbooks on topics related to Alternative Investment Strategies and Fixed-Income Securities.

Dr. Martellini has served as a consultant for various institutional investors, investments banks and asset management firms both in Europe and in the United States on questions related to active asset allocation decisions and alternative investment strategies, and is a regular speaker in seminars and conferences on these subjects.

PRESENTATION