s institutional investors take a more active in-terest in alternative investments, a significantgap has emerged between the culture andexpectations of those investors and hedgefund managers. Pension plan sponsorstypically require transparency from their managers and im-pose numerous restrictions on their investment mandatesbecause of regulatory requirements such as ERISA rules;hedge fund managers rarely provide position-level trans-parency and bristle at any restrictions on their investmentprocess, saying that restrictions can hurt performance. Plansponsors require a certain degree of liquidity in their assetsto meet their pension obligations and also desire significantcapacity because of their limited resources in managing largepools of assets; hedge fund managers routinely impose lock-ups of one to three years, and the most successful managershave the least capacity to offer, in many cases returning in-vestor capital once they make their personal fortunes. Andas fiduciaries, plan sponsors are hypersensitive to the outsizefees that hedge funds charge and are concerned about mis-aligned incentives induced by performance fees; hedge fundmanagers argue that their fees are fair compensation for theirIn Theory: Hasanhodzic and LoAttackClonesoftheBy Jasmina Hasanhodzicand Andrew W. Lo Hedge funds are considered by many investors to be an attractive investment, thanks inlarge part to their diversification benefits and distinctive risk profiles. The major drawbacksare their high fees and lack of transparency. Research by Jasmina Hasanhodzic and AndrewW. Lo of the Massachusetts Institute of Technology raises the possibility of creating passiveportfolios that provide similar risk exposures to those of hedge funds at lower costs and withgreater transparency. Hasanhodzic and Lo find that for certain hedge fund strategies, thesehedge fund “clones” perform well enough to warrant serious consideration.54 • INSTITUTIONAL INVESTOR’S ALPHA •JUNE 2006AIllustrations by Edel Rodriguez for AlphaFor Internal Use OnlyFor Internal Use Onlyunique investment acumen — and at least for now, the mar-ket seems to agree.This cultural gap raises the natural question of whetherit is possible to obtain hedge-fund-like returns withoutinvesting in hedge funds. In other words, can hedge fundreturns be cloned?In a series of recent papers, Harry Kat and Helder Palaroof the Cass Business School at City University in Lon-don show that sophisticateddynamic trading strategiesinvolving liquid futures con-tracts can replicate many ofthe statistical properties ofhedge fund returns. In fact,in a 2001 paper with Di-mitris Bertsimas and LeonidKogan of the MassachusettsInstitute of Technology, weshow that the risk/returncharacteristics of securitieswith very general payofffunctions (like hedge fundsor complex derivatives) canbe synthetically replicated toan arbitrary degree of accu-racy by dynamic tradingstrategies — called epsilon-arbitrage strategies — involvingmore liquid instruments. Although these results are encour-aging for the hedge fund replication problem, the strategiesare quite complex and not easily implemented by the typi-cal institutional investor.In this article we take a slightly different tack: We con-struct “linear clones” — buy-and-hold portfolios of com-mon risk factors like the Standard & Poor’s 500 and U.S.dollar indexes, with portfolio weights estimated by a lin-ear regression of a fund’s historical returns on market fac-tors — of a large number of individual hedge funds in theTASS Hedge Fund Database. We then compare theircharacteristics to those of the corresponding funds fromwhich the clones are derived.If a hedge fund generates part of its expected returnand risk profile from certain common risk factors, it maybe possible to design a low-cost, buy-and-hold portfolio— not an active, dynamic trading strategy — that cap-tures some of that fund’s risk/reward characteristics bytaking on just those risk exposures. For example, if a par-ticular long-short equity hedge fund is 40 percent longgrowth stocks, it may be possible to create a passive port-folio that has similar characteristics through a long-onlyposition in a passive growth portfolio coupled with a 60percent short position in stock index futures.The magnitude of hedge fund alpha that can be cap-tured by a linear clone depends, of course, on how muchof a fund’s expected return is driven by common risk fac-tors versus manager-specific alpha. This can be measuredempirically. Although portable-alpha strategies have be-come fashionable lately among institutions, our researchsuggests that for certain classes of hedge fund strategies,portable beta may be an even more important source ofuntapped expected returns and diversification.BEFORE TURNING TO OUR empirical analysis, weprovide two concrete examples that span the extremes ofthe hedge fund replication problem. For one hedge fundstrategy, we show that replication can be accomplishedeasily; for another strategywe find replication to bealmost impossible usinglinear models.The first example is ahypothetical strategy weproposed several years agocalled “Capital DecimationPartners,” or CDP, whichyields an enviable trackrecord that many investorswould associate with a suc-cessful hedge fund: a 43.1percent annualized meanreturn and 20.0 percent an-nualized volatility, imply-ing a Sharpe ratio of 1.90,and with only six negativemonths over the 96-month simulation period from January1992 through December 1999 (see Table 1).So what is CDP’s secret? The investment strategy in-volves shorting out-of-the-money S&P 500 put optionson each monthly expiration date for maturities less thanor equal to three months, and with strikes approximately7 percent out of the money.The essence of this strategy is the provision of insur-ance. CDP investors receive option premiums for each op-tion contract sold short, and as long as the option contractsexpire out of the money, no payments are necessary. Fromthis perspective the handsome returns to CDP investorsseem more justifiable: In exchange for providing downsideprotection, CDP investors are paid a risk premium in thesame way that insurance companies receive regular pay-ments for providing earthquake or hurricane insurance.Given the relatively infrequent nature of 7 percentlosses, CDP’s risk/reward profile can seem very attractivein comparison to more traditional investments, but thereis nothing unusual or unique about CDP. Investors