Question:

Jaeger catalogs hedge fund strategies (Chapter 5, Individual Hedge Fund Strategies). We are keenly interested in viewing each strategy through the prism of its compensated risk premia (i.e., to which risks does the strategy deliberately seek exposure and, consequently, compensation in the form of excess returns).

(i) Based on the risk premia discussed, which strategies are MOST amenable to Andrew Lo’s linear clone replication method?
(ii) Which hedge fund strategies are LEAST amenable to the linear clone replication employed by Lo?

Answer:

Based only on the Jaeger reading, these can be debated but the point is to be thinking about the risk premia assocated with each strategy.

(i) Good candidates for clone replication

* Long/short has some exposure to broad equity risk premium. But may also have exposure to the Fama-French small firm and value risk premia.
* Equity market neutral has some exposure to HML, SMB and UMD factors
* Convertible arbitrage is a good candidate for replication given that static returns are no related to pricing inefficiencies but rather stem directly from systematic risk factors.
* Volatility arbitrage in theory ought to be a candidate, but see Lo on difficulty of operationalizing this factor as of yet.
* Global macro strategies vary, but some of the sub-classes ought to exhibit high factor exposure to currencies, interest rates, etc.
* Systematic managed futures strategies, by definition, ought to be candidates for factor replication (e.g., trend-following)

(ii) Strategies that ought to be hard to clone replicate

* Equity market timing ought to be hard to replicate.
* Short-selling ought to be hard to replicate given high dependence on manager skill.
* Capital structure ought to be difficult to replicate given complexity and manager dependence
* Event-driven, by definition, ought to be hard to replicate.

Others:
Fixed income arbitrage has many different sub-strategies.