A Learning-Based Linear Replicator for Hedge Fund Indexes

38 Pages Posted: 13 Sep 2007 Last revised: 15 Feb 2010

See all articles by Fei Pan

Fei Pan

Purdue University - Krannert School of Management

Kwei Tang

Purdue University - Krannert School of Management

Date Written: December 2009

Abstract

There has been great interest in creating portfolios using common liquid instruments to replicate hedge fund returns. In a recent article, Hasanhodzic and Lo (2007) demonstrate that a factor-based approach based on a linear regression model with 5 tradable risk factors can adequately replicate monthly returns of 1,610 hedge funds in 1986 to 2005. We propose a learning-based linear replication algorithm to enhance the linear model. Results show that our approach can improve the replicating capability of linear replicator, especially for some nonlinear and dynamic strategies, e.g., Event-driven and Emerging Markets. The annualized root mean squared error is improved by 40% and 34%, respectively. The new method can automatically detect the market changes and separate return points into different polyhedral regions, even high dimensions (multiple risk factors). By using 12 major strategy indexes' monthly returns compiled by 7 data vendors from their inception date until December 2008, we examine our method with six common risk factors and find that our algorithm can improve explanatory of hedge fund index returns. The performance of our new replicator is also tested by cloning out-of-sample monthly returns through using five out of these six factors.

Keywords: Hedge fund indexes; Hedge fund replication; Piecewise linear regression; Clustering

JEL Classification: C14, C63, G1, G24

Suggested Citation

Pan, Fei and Tang, Kwei, A Learning-Based Linear Replicator for Hedge Fund Indexes (December 2009). Available at SSRN: https://ssrn.com/abstract=1013243 or http://dx.doi.org/10.2139/ssrn.1013243

Fei Pan (Contact Author)

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

HOME PAGE: http://panfei.googlepages.com

Kwei Tang

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

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