Should we give hedge funds clones a chance?

Purpose - The purpose of this paper is to examine the possibility of creating hedge funds "clones" using liquid exchange traded instruments. Design/methodology/approach - Authors analyze the performance of fixed weight and extended Kalman filter generated clone portfolios (EKF) for 14 hedge fund strategies from February 2004 to September 2009. EKF approach does not indeed impose any normality constraints on the error terms which allow the filter to find the optimal recursive process by itself. Such models could adjust even faster to sudden shifts in market conditions vs a standard Kalman filter. Findings - For five strategies out of 14, this work finds that EKF clones outperform their corresponding indices. Thus, for certain strategies, the possibility of cloning hedge fund returns is indeed real. Results should be however considered with caution. Practical implications - This paper suggests that the most important benefits of clones are to serve as benchmarks and to help investors to better understand the various risk factors that impact hedge fund returns. Originality/value - Rather than using fixed- weight and rolling windows approaches (as Hasanhodzic and Lo), this work considers an extended version of the Kalman filter, a computational algorithm that better captures the time changing dynamics of hedge fund returns. Also, in order to be practical, this research considers investable factors and that the models themselves could not be constant over time.