Even complex hedge fund strategies can be replicated.
So says Andrew W. Lo, Harris & Harris Group professor and director of the Massachusetts Institute of Technology Laboratory for Financial Engineering, Cambridge, Mass. Mr. Lo is working on a paper on constructing a buy-and-hold portfolio of options that he says will replicate the returns of hedge fund strategies, such as merger arbitrage funds, that produce non-normal returns.
For pension plans, such a portfolio would give them a way to produce hedge-fund-like returns without paying high hedge fund fees. For researchers and consultants, Mr. Lo's work would help solve an age-old problem: how to go about analyzing a hedge fund that produces uneven returns.
Traditionally, consultants and researchers analyze investment portfolios using the standard mean-variance approach, which looks at how much of the returns of an actively managed portfolio vary from the portfolio's average return. Additionally, they use linear regression analysis to produce an "R-squared," which shows how much of the return of an actively managed portfolio can be statistically explained by its benchmark. An R-squared of 50%, for example, means 50% of a portfolio's returns can be explained by the broad market. But in complex hedge fund strategies, such as merger and fixed-income arbitrage funds, neither of these analyses works because these funds typically produce a steady stream of positive returns with a small risk of blow-up.
James McKee, director of hedge fund research at Callan Associates Inc., San Francisco, said: "Analyzing hedge funds with non-linear return distributions has been a problem. I've heard people talk about it, but no one has reached a general consensus on how to solve it."