Active Factor Investing: Hedge Funds vs. the Rest of Us

The article discusses the idea of replicating the returns of hedge funds using liquid investment alternatives, known as "hedge fund clones." These clones aim to alleviate the issues of lack of transparency, liquidity, and high fees that hedge funds are criticized for. However, it is unclear if hedge fund returns can be replicated as they are often based on proprietary, actively managed strategies that are difficult to replicate. The article suggests that hedge fund returns may be driven by exposures to latent risk factors, which could be replicated using exchange-traded funds (ETFs). The article describes a methodology for replicating hedge fund returns using ETFs and focusing on cloneable hedge funds, those whose returns are mostly driven by exposures to latent risk factors. It suggests that this approach results in outstanding long-term risk-adjusted performance and that the ETF portfolios even deliver marginally better performance than the original hedge funds.