Hedge Fund Replication: From a Linear Model to a Markovian Model

Abstract

Hedge fund managers have historically claimed that they generate significant alpha to justify their management and performance incentive fees. However, researchers have recently questioned these claims and suggest that most hedge funds derive returns primarily from alternative sources of beta. In this work, we construct both linear and Markov regime-switching (MRS) clones of hedge funds across six fund classes using a variety of liquid risk factors. Out-of-sample performance testing showed that although linear clones often fell short to their hedge fund counterparts, MRS clones were able to outperform their hedge fund counterparts. As always, there is an important tradeoff between simplicity and performance, but the results of our research suggest that MRS clones are a worthwhile possible alternative to hedge funds.