27. Hedge Funds: Replication and Nonlinearities

  1. H. Kent Baker and
  2. Greg Filbeck
  1. Mikhail Tupitsyn1 and
  2. Paul Lajbcygier2

Published Online: 2 APR 2013

DOI: 10.1002/9781118656501.ch27

Alternative Investments: Instruments, Performance, Benchmarks, and Strategies

Alternative Investments: Instruments, Performance, Benchmarks, and Strategies

How to Cite

Tupitsyn, M. and Lajbcygier, P. (2013) Hedge Funds: Replication and Nonlinearities, in Alternative Investments: Instruments, Performance, Benchmarks, and Strategies (eds H. K. Baker and G. Filbeck), John Wiley & Sons, Inc., Hoboken, NJ, USA. doi: 10.1002/9781118656501.ch27

Author Information

  1. 1

    Ph.D. Student, Department of Accounting and Finance, Monash University

  2. 2

    Associate Professor, Department of Accounting and Finance and the Department of Econometrics and Business Statistics, Monash University

Publication History

  1. Published Online: 2 APR 2013
  2. Published Print: 18 MAR 2013

ISBN Information

Print ISBN: 9781118241127

Online ISBN: 9781118656501

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Keywords:

  • hedge fund replication;
  • factor-based model;
  • nonlinear risk exposures;
  • generalized additive model

Summary

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.