Hedge Fund Replication

Asset replication, in general, deals with the concept of replicating the returns of one asset with the returns of several other assets. The term does not refer to derivatives replication, in which one uses linear instruments to replicate nonlinear ones, as described in Chapters 1 and 5. The simplest example of asset replication is a mutual fund or exchange-traded fund (ETF) on the S&P 500 index. An ETF is similar to a mutual fund (which can be bought or sold at the end of each trading day for its net asset value) except that it can be traded throughout the trading day. The S&P 500 index owner, Standard and Poor’s Financial Services LLC, does not provide investments into the index inasmuch as it is largely a ratings agency and financial research company. Mutual fund providers such as the Vanguard Group must replicate the returns of the official index S&P 500 index in order to provide a tracking or replicating mutual fund. The replication is fairly straightforward, because Standard and Poor’s provides the names of all 500 underlying stocks as well as its market capitalization weighting methodology. An exact replication strategy would require one to hold all 500 stocks at all times in exact proportion to their weights in the index. Vanguard’s main concern is tracking error, a measure of how closely a replicating fund follows the index to which it is benchmarked. The most common measure of tracking error is the root-mean-square of the difference between the mutual fund returns and the index returns. For a mutual fund, the tracking error is based on closing day prices, whereas for an ETF such as the SPDR S&P 500 ETF—the “spiders” of State Street Global Advisors (SSgA)—the tracking error uses intraday prices. Because of transaction costs and fees, both tracking mutual funds and ETFs slightly underperform the reference index. Replicating or tracking funds and ETFs are available for a wide range of popular equity and bond indices such as the Russell 3000, FTSE 100, CAC 40, SX5E, and Barclays Aggregate Bond Index (formerly the Lehman Brothers Aggregate Bond index).