Hedge funds: Replication and nonlinearities

Hedge funds were once considered to derive returns solely from managers superior skill for security selection and market timing as well as their ability to find and quickly exploit arbitrage opportunities in the market. Recently, researchers have challenged this view, as academic studies have revealed that a large part of hedge fund returns stems from systematic risk premiums rather than abnormal performance, or alpha. As a result of the revelation that an alternative beta exists and drives hedge fund returns, many researchers have been motivated to determine if hedge fund returns can be replicated inexpensively, similar to index fund replication such as Vanguard s S P 500 product. So far, researchers have proposed several approaches to replication. However, the task is still a work-in-progress in terms of successful implementation. Hedge funds dynamic investment strategies and flexibility to trade derivatives lead to complex nonlinear exposures to systematic risk, which existing linear models fail to capture. Until these nonlinear features are taken into account, any replication model is unlikely to succeed and evolve into a viable alternative to direct hedge fund investing. Therefore, this chapter introduces a new nonlinear model of hedge fund returns that paves the way toward nonlinear replication.