Regular(Ized) Hedge Fund Clones

This article addresses the problem of portfolio construction in the context of efficient hedge fund investments replication. We propose a modification to the standard à la Sharpe “style analysis” by introducing a constraint on the asset weights 1-norm and 2-norm. This constraint regularizes the optimization problem, allows efficient selection of relevant factors - especially among a set of correlated factors - and has significant effects on the stability of the resulting asset mix and the risk-return characteristics of the replicating portfolio. The empirical results suggest that the norm-constrained replicating portfolios exhibit significant correlations with their benchmarks, often higher than 0.9; have a fraction, that is about half to two thirds, of active positions relative to those determined through the standard method; and are obtained with turnover, which is in some instances about one fourth of that for the standard method