In Search of Missing Risk Factors: Hedge Fund Return Replication with ETFs

Fully spanning the space of potential risk factors with tradable liquid portfolios is paramount in the context of a risk-based factor model. We develop a factor selection methodology of spanning the space of hedge fund risk factors with all available exchange traded funds (ETFs). We demonstrate the efficacy of the methodology with out-of-sample hedge fund return replication, and find that the replication accuracy increases with the number of ETFs available. This is consistent with our interpretation of ETF returns as proxies to alternative risk factors driving hedge fund returns. 

We further consider portfolios of “cloneable” and “non-cloneable” hedge funds, defined as top and bottom in-sample R2 matches. We find superior risk-adjusted performance for “non-cloneable” funds, while “cloneable” funds fail to deliver significantly positive risk-adjusted performance. Our methodology provides value in both identifying skilled managers of “non-cloneable” hedge funds, as well as successfully replicating out-of-sample returns that are due to alternative risk exposures of “cloneable” hedge funds, thus providing a transparent and liquid alternative to investors who may find these return patterns attractive.