The Pros and Cons of Passive Hedge Fund Replication
Noël Amenc and David Schröder
EDHEC Risk and Asset Management Research Centre
April 2009
Introduction
The remarkable rise of the hedge fund industry in the last decade of the twentieth century would not have been possible without the great demand of wealthy private clients for sophisticated investment opportunities. Institutional investors, by contrast, long remained reluctant to invest in hedge funds. Although clearly drawn to the returns and the risk reduction potential of these investments, they have only recently started to shift a part of their assets to hedge funds.
The main reasons for this reluctance are the high fees charged by successful hedge fund managers and the relative opacity of the funds, along with the operational risks associated with investments in weakly regulated entities. The conflict between the institutional investor’s requirements for highly transparent investments and the black-box nature of hedge funds has prompted attempts to obtain hedge fund-like returns without actually investing in hedge funds. Investment banks seized the opportunity and have started to create synthetic hedge fund products whose aim is to replicate hedge fund-like returns at lower cost.
However, whether these replication products really offer replication of actual hedge fund returns remains to be seen. The academic debate, as reflected in a recent publication of the EDHEC Risk and Asset Management Research Centre (Amenc et al 2007)1, revolves around two major issues:
