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Alternative Beta Strategies and Hedge Fund Replication

ISBN: 978-0-470-75446-7
272 pages
October 2008
Alternative Beta Strategies and Hedge Fund Replication (047075446X) cover image


There s a buzzword that has quickly captured the imagination of product providers and investors alike: "hedge fund replication". In the broadest sense, replicating hedge fund strategies means replicating their return sources and corresponding risk exposures. However, there still lacks a coherent picture on what hedge fund replication means in practice, what its premises are, how to distinguish di erent approaches, and where this can lead us to.

Serving as a handbook for replicating the returns of hedge funds at considerably lower cost, Alternative Beta Strategies and Hedge Fund Replication provides a unique focus on replication, explaining along the way the return sources of hedge funds, and their systematic risks, that make replication possible. It explains the background to the new discussion on hedge fund replication and how to derive the returns of many hedge fund strategies at much lower cost, it differentiates the various underlying approaches and explains how hedge fund replication can improve your own investment process into hedge funds.

Written by the well known Hedge Fund expert and author Lars Jaeger, the book is divided into three sections: Hedge Fund Background, Return Sources, and Replication Techniques. Section one provides a short course in what hedge funds actually are and how they operate, arming the reader with the background knowledge required for the rest of the book. Section two illuminates the sources from which hedge funds derive their returns and shows that the majority of hedge fund returns derive from systematic risk exposure rather than manager "Alpha". Section three presents various approaches to replicating hedge fund returns by presenting the first and second generation of hedge fund replication products, points out the pitfalls and strengths of the various approaches and illustrates the mathematical concepts that underlie them.

With hedge fund replication going mainstream, this book provides clear guidance on the topic to maximise returns.

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Table of Contents

Preface ix

1 Breaking the Black Box 1

1.1 New popularity, old confusion 1

1.2 The challenges of understanding hedge funds 2

1.3 Leaving Alphaville 3

1.4 The beauty of beta 4

1.5 Alternative versus traditional beta 4

1.6 The replication revolution 5

1.7 Full disclosure 6

2 What AreHedge Funds,Where Did They Come From, and Where Are They Going? 7

2.1 Characteristics of hedge funds 7

2.2 Hedge funds as an asset class 11

2.3 Taxonomy of hedge funds 11

2.4 Myths, misperceptions, and realities about hedge funds 15

2.5 A short history of hedge funds 22

2.6 The hedge fund industry today 26

2.7 The future of hedge funds – opportunities and challenges 30

3 The Individual Hedge Fund Strategies’ Characteristics 37

3.1 Equity Hedged – Long/Short Equity 37

3.2 Equity Hedged – Equity Market Neutral 41

3.3 Equity Hedged – Short Selling 44

3.4 Relative Value – general 45

3.5 Relative Value – Fixed Income Arbitrage 46

3.6 Relative Value – Convertible Arbitrage 51

3.7 Relative Value – Volatility Arbitrage 58

3.8 Relative Value – Capital Structure Arbitrage 60

3.9 Event Driven – general 62

3.10 Event Driven – Merger Arbitrage 64

3.11 Event Driven – Distressed Securities 67

3.12 Event Driven – Regulation D 69

3.13 Opportunistic – Global Macro 70

3.14 Managed Futures 75

3.15 Managed Futures – Systematic 76

3.16 Managed Futures – Discretionary 79

3.17 Conclusion of the chapter 81

4 Empirical Return and Risk Properties of Hedge Funds 83

4.1 When the Sharpe ratio is not sharp enough 83

4.2 Challenges of hedge fund performance measurement – the issue with hedge fund indices 84

4.3 Sources of empirical data 89

4.4 Risk and return properties of hedge fund strategies 90

4.5 Comparison with equities and bonds 93

4.6 Deviation from normal distribution 94

4.7 Unconditional correlation properties 94

4.8 Conditional returns and correlations 98

4.9 Hedge fund behavior in extreme market situations 105

4.10 Benefits of hedge funds in a traditional portfolio 107

4.11 Quantitative portfolio optimization for hedge funds revisited 109

4.12 Summary of empirical properties 112

4.13 Appendix: Data providers for past hedge fund performance 113

5 The Drivers of Hedge Fund Returns 117

5.1 Alpha versus beta 117

5.2 The enigma of hedge fund returns 119

5.3 Hedge fund returns: how much is alpha? 121

5.4 The efficient market hypothesis 123

5.5 Questioning the efficient market hypothesis: behavioral finance 125

5.6 The theoretical framework of modern finance: asset pricing models and the interpretations of alpha 128

5.7 Systematic risk premia: the prevalence of beta in the global capitalmarkets 131

5.8 Risk premia and economic functions 138

5.9 Market inefficiencies: the ‘search for alpha’ 140

5.10 An illustration of the nature of hedge fund returns 143

5.11 The decrease of alpha 145

5.12 The beauty of alternative beta 147

5.13 The future of hedge fund capacity 149

5.14 Momentum and value 150

5.15 Active strategies and option-like returns 152

5.16 Why manager skill matters 154

5.17 Buyer beware: some final words of caution about hedge fund returns 155

6 A First Approach to Hedge Fund Replication – Linear Factor Models and Time Series Replication Models 157

6.1 Revisiting Sharpe’s approach 157

6.2 Understanding linear factor analysis: criteria for the factor model approach 158

6.3 The model specification problem 159

6.4 The data quality problem 160

6.5 The development of hedge fund factor models 161

6.6 Basic and advanced factor models for hedge fund strategies 161

6.7 How good are our models? 165

6.8 Variability of risk exposures and persistence of factor loadings 166

6.9 Can we create hedge fund replications with linear factor models? 168

6.10 The limitations of linear factor models 176

6.11 Currently available hedge fund replication products based on RFS 178

6.12 Summary and conclusion of the chapter 180

7 The Distributional Approach 183

7.1 Being less ambitious 183

7.2 General principles of the distributional approach 184

7.3 Integration of correlations and dependencies 186

7.4 Limitations of the replication approach 187

7.5 The empirical results of the distributional method 187

7.6 Conclusion for the distributional approach 188

8 Bottom up: Extraction of Alternative Beta and ‘Alternative Beta Strategies’ 191

8.1 The rule-based alternative 191

8.2 What hedge fund investors really want 193

8.3 The first ‘alternative beta’ strategies 194

8.4 Relating hedge fund returns and risk premia: what we can model 196

8.5 Alternative beta strategies for individual hedge fund styles and strategy sectors 197

8.6 New exotic beta 208

8.7 The question of asset allocation 209

8.8 The limitations of hedge fund replication 210

8.9 A note on the issue of liquidity 210

8.10 Summary 211

9 Hedge Fund Portfolio Management with Alternative Beta Strategies 213

9.1 The tasks of the hedge fund portfolio manager 213

9.2 The lure of saving fees 214

9.3 The limitations of hedge fund replication 215

9.4 The role of asset allocation 216

9.5 Separation of tasks for the fund of funds managers 216

9.6 The idea of a core–satellite approach to hedge fund investing 217

9.7 Isolating pure alpha 218

9.8 The first part in the investment process: allocation to strategy sectors 218

9.9 Implementation of tactical asset allocation in a core–satellite approach to hedge fund portfolios 223

9.10 The second element: manager selection 226

9.11 Active post-investment risk management 231

9.12 Summary and conclusion 238

10 Replication and the Future of Hedge Funds 239

10.1 Beyond alpha 239

10.2 What do investors say so far? 239

10.3 Replication and the four key challenges to the hedge fund industry 240

10.4 Replication in reality 241

10.5 Replication and hedge fund growth 242

10.6 Hedge funds in the broader context: The future of absolute return investment 243

References and Bibliography 245

Index 253

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Author Information

Lars Jaeger holds a PhD degree in theoretical physics from the Max-Planck Institute for Physics of Complex Systems, Dresden. He studied physics and philosophy at the University of Bonn, Germany, and Ã?cole Polytechnique, Paris. After his post-doctorate studies in Dresden, Lars began his finance career as a quantitative researcher on econometric and mathematical modeling of financial markets at Olsen & Associates AG in Zurich. He subsequently joined the Hedge Fund group of Credit Suisse Asset management, where he was responsible for risk management and quantitative strategy analysis. Lars is a founding partner of saisGroup, an investment firm specializing on alternative investment strategies which in 2001 merged with Partners Group, where he is now a partner heading the group â??Alternative Beta Strategesâ??. Lars holds the CFA charter and is a certified Financial Risk Manager (FRM). He is the author of numerous research publications and the books Risk Management of Alternative Investment Strategies, published in 2002 with Financial Times Prentice Hall, The New Generation of Risk Management for Hedge Funds and Private Equity (ed.) published by Euromoney in 2003, and Through the Alpha Smokescreen: A guide to hedge fund return sources, published by Institutional Investors (2005). Lars lives with his wife and three children near Zurich, Switzerland.
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