Francois-Serge Lhabitant

Associate Professor of Finance at EDHEC Business School, Professor of Finance at the University of Lausanne, and a senior advisor to Kedge Capital Partners

Bio/Contact Information (Edhec)
Research (SSRN)
Interview  (Edhec)
Relevant Postings (AllAboutAlpha.com)

Hedge Fund Replication: Old theory, new interest, inconclusive results

Consultant and journalist Pierre Saint-Laurent* continues his coverage of EDHEC’s Asset Management Days in Geneva this week for All About Alpha.  On Tuesday, he attended a much anticipated presentation on hedge fund replication featuring researchers Noël Amenc, Jean-Christophe Meyfredi, François-Serge Lhabitant and Walter Géhin.  Other industry leaders** joined the EDHEC group on a subsequent panel discussion. Here again is Saint-Laurent’s dispatch from Geneva.

Hedge fund replication is controversial. For some, it’s a gallant effort to lower fees, increase transparency and boost liquidity. For others, it’s a work in progress whose promoters may be getting ahead of themselves.

But one thing is for sure: Hedge fund replication is not a new subject according to EDHEC researchers. The general concept of factor modeling dates back decades, and one of its most famous applications to hedge fund returns was completed by Fung and Hsieh in their 2002 style-based research.

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“To the point: Hedge funds have no science but to bet on heads or tails”

By: Edmond Warner, Daily Telegraph
Published: February 1, 2007

This article suggests that hedge funds, under pressure to perform, are simply levering-up 50/50 (”fair”) bets.  According to its author, hedge funds use “pseudo-scientific investment models that are no more than cottage industry gambles”. Unfortunately, he dredges up tired stereotypes as proof and neglects to back them up with any applicable facts.  So as a public service, we put this article into our “B.S.” detector to see what would come out the other end.

“(hedge fund) fees dwarf those paid to conventional money managers”

As we have discussed several times (here, here, here, here & here), one cannot look solely at a fund’s sticker price to determine its value.  Long-only funds have lower sticker prices because many of them are closet index funds.  And index funds have a low fee for a reason – there is very little work involved.

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Professor Harry Kat of City University, London has the hedge fund industry in a tizzy about what has become known as his hedge fund “replication” technique.  Today, he straightens out the record with the following statement:

“Since the launch of FundCreator we have received various emails from people who, put simply, stated that ‘You guys are mad, there is no way you can replicate the best hedge funds’. Comments like these betray a serious misconception of what synthetic funds are really about. In this brief note I will attempt to correct this.

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By: Ramin Baghai-Wadji & Stefan Klocker, Vienna University of Economics and Business Administration
Published: May 20, 2006

Assuming hedge fund beta exists, determining the amount of alpha produced by a manager requires one to know what particular hedge fund beta a manager is leveraging.  So the identification of a hedge fund as being say, ”merger arb” or “distressed” is critical in determining value added by the manager.

Problem is, asking managers to self identify may not always be the best strategy.  Managers would face a fundamental conflict as their choice might make them look like a hero or a dog.

This paper was first presented in October 2006 at the Annual Meeting of the German Finance Association.  It proposes a new methodology for identifying the strategies of hedge funds by grouping them together into natural clusters using a “self-organizing map” (a.k.a. “a neural network”).

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