Seven factors that capture most of hedge funds' returns

The Economist magazine just published an article that talked about "synthetic" hedge funds, or replicating hedge fund returns using factor models. The original research cited can be found here. (For those of you who want a primer on factor models, I have written an article on this topic previously.) The seven factors are (are you ready?):

1) excess return on the S&P 500 index;
2) a small minus big factor constructed as the difference of the Wilshire small and large
capitalization stock indices;
3) excess returns on portfolios of lookback straddle options on currencies;
4) excess returns on portfolios of lookback straddle options on commodities;
5) excess returns on portfolios of lookback straddle options on bonds;
6) the yield spread of the US ten year treasury bond over the three month T-bill, adjusted for the duration of the ten year bond;
7) the change in the credit spread of the Moody's BAA bond over the 10 year treasury bond, also appropriately adjusted for duration.

According to the researchers, factors 3)-5) are constructed to replicate the maximum possible return to trend-following strategies on their respective underlying assets.

See, it is not that difficult to run a hedge fund after all!