Hedge fund replication

The latest issue of The New Yorker has a good article on the latest trend of hedge fund replication.

Kat provided many of the mathematical ideas. Palaro, an experienced programmer, did most of the computer work. Rather than trying to emulate a hedge fund’s monthly return—a nearly impossible task—the researchers sought to match the fund’s results over a period of several years, as well as the other statistical properties of its performance that investors were likely to care about most: the volatility of the returns, their correlation with the stock market, the likelihood of suffering extreme losses.

In the spring of last year, Kat sent me an e-mail in which he expressed confidence that he and Palaro would succeed. “It is possible to design mechanical futures-trading strategies which generate returns with the same, and often better, risk-return properties as hedge funds,” he said. “This means investors can have hedge-fund returns but without the massive fees and all the other drawbacks that come with the real thing.”

By the end of 2006, Kat and Palaro had finished writing their software program, which they called FundCreator, and had conducted several successful trials. In April, Kat demonstrated the software for me at his office on the Cass Business School’s campus. A hefty man with blue eyes and spiky brown hair, Kat was wearing jeans, sneakers, and a garish striped polo shirt. When he turned on his computer, a hideous animal’s head, replete with fangs and horns, appeared on the screen. Kat, an avid heavy-metal fan who plays the electric guitar, said, “That’s the FundCreator monster. Now let’s get started.”

I entered my name and address and the amount of money—a hundred million dollars—I wanted the system to manage. Then I had to select the kinds of futures contracts I wanted to trade. The choices included equity futures, interest-rate futures, commodity futures, and currency futures. These futures are the building blocks that FundCreator uses to simulate hedge-fund investments. Next, I was directed to a screen that allowed me to choose from a list of several thousand hedge funds. I asked Kat if I could replicate one run by George Soros. Using a pull-down menu, Kat clicked on Quantum Fund NV, which for many years was Soros’s investment flagship and often had an annual return of twenty-five per cent or more. A Web page appeared that was full of statistics detailing Quantum’s record going back to 1985. It showed that the annual volatility of Quantum’s returns—the amount they varied from year to year—was high (twenty-four per cent), indicating that the fund was a risky investment. The coefficient of correlation between Quantum’s returns and the S. & P. 500—a statistical measure of how closely the fund’s performance tracked the stock index—was low (0.35), indicating that Quantum provided valuable diversification. “If you say you want to replicate Quantum, you leave it all as it is,” Kat said, pointing to boxes displaying each figure. “But you can also do some genetic engineering. If you want zero correlation with the S. & P. 500, you write in zero. If you leave it all as it is, that is called fund replication. If you change something, that is called fund creation.”