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While some herald the development of hedge fund replicators as marking the industry's own ETF revolution, others are expressing concern over the clones' properties since traditional hedge funds are human-capital intensive financial operations and the high concentration of specialized talent is the reason for the industry's remarkably high remuneration structure. Taking much of the human capital out of hedge fund strategies is a pre-requisite for bringing the costs of replicators down, but it is one that many feel comes at a high price in terms of adaptivity, dynamic flexibility, and risk selection. In this article, I study a continuous-time model of arbitrage selection, which sheds light on this trade-off and provides added perspective on the issue. Several important results are obtained. First, a hedge fund's optimal trade selection criterion depends on a risk-reward trade-off that balances the expected gains from the trade and the uncertainty surrounding the trade's speed of convergence. Furthermore, the ability to select potential arbitrage trades generates a value for the fund's net discounted cash flows that resembles prototypical option-pricing formulas. In addition, the value added of human capital to a hedge fund's operations is dramatically enhanced when the fund deals in potential arbitrage trades for which there is a significant amount of uncertainty regarding the speed of convergence or the chances of divergence. Additional observations are made. |
