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Regular(Ized) Hedge Fund Clones

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Document pages: 34 pages

Abstract: This article addresses the problem of portfolio construction in the context of efficient hedge fund investments replication. We propose a modification to the standard à la Sharpe ‘style analysis’ where we augment the objective function with a penalty proportional to the sum of the absolute values of the replicating asset weights, i.e. the norm of the asset weights vector. This penalty regularizes the optimization problem, with significant impacts on the stability of the resulting asset mix and the risk and return characteristics of the replicating portfolio. Our results suggest that the norm-constrained replicating portfolios exhibit significant correlations with their benchmarks, often higher than 0.9, have a fraction, i.e. about 1 2 to 2 3, of active positions relative to those determined through the standard method, and are obtained with turnover which is in some instances about 1 4 of that for the standard method. Moreover, the extreme risk of the replicating portfolios obtained through the regularization method is always lower than that exhibited by currently available commercial hedge fund investment replication products.

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