Cloning Risk Factor-driven Hedge Funds with ETFs
December 30, 2014 - Mutual/Hedge Funds
Does the expanding set of exchange-traded funds (ETF) support reliable replication (cloning) of future returns for some hedge funds? In their December 2014 paper entitled “Smart Beta ETF Portfolios: Cloning Beta Active Hedge Funds”, Jun Duanmu, Yongjia Li and Alexey Malakhov test replication of top risk factor-driven (beta-active) hedge funds using portfolios of ETFs. The selected hedge funds perform well historically and are especially suited to cloning because of their dependence on known risk factors. The hedge fund selection and cloning process involves repeating four steps annually based on two years of monthly historical data. Specifically, each year the authors:
- Identify the fourth of hedge funds with returns most strongly correlated with known risk factors.
- Iterate cluster analysis 100 times to identify ETFs most representative (highest correlation of monthly returns with the mean return of the cluster) of up to 100 clusters to serve as risk factor proxies.
- Use an optimization tool on each of the 100 cluster analyses to combine representative ETFs into 100 clone models of pre-fee (risk factor perspective) monthly returns for each target hedge fund.
- Apply the Bayesian information criterion (which addresses data snooping bias via a penalty for model complexity) to select the best clone model for each target hedge fund.
They then test, starting in 2005 (when enough historical ETF data become available), the ability of winning clone models to match post-fee (investor perspective) monthly returns of target hedge funds for one year out-of-sample. They mitigate backfill bias in hedge fund returns (only funds with good starts begin publicizing their returns) by excluding the first 24 months of reported returns. They suppress survivorship bias by including funds that later stop reporting. Using monthly net returns for 2,014 hedge funds (963 live and 1,051 dead) during 1994 through 2012 and monthly returns for 1,313 passive ETFs as available during 1997 through 2012, they find that: Keep Reading