Nonlinear hedge fund index clones?

Abstract

Cloning hedge fund indexes circumvents the many challenges associated with direct hedge fund investment. Theoretically, hedge fund indexes could have nonlinear exposures to the economic risk factors that drive their returns and may require nonlinear clones. By using flexible statistical models, we enable the choice between linear and nonlinear clones. We demonstrate that for certain hedge fund styles, nonlinear index clones are crucial for high fidelity replication. Nonlinear clones both facilitate economic insights to cloning and enhance the best linear clones. JEL classification: G10, G23, C15