Hedging your Bets

The improvement of risk / return characteristics of equity and bond portfolios when hedge funds are introduced is a stylised fact, due mostly to the negative, low or zero correlation of hedge funds with stock and bond indices, and their ability to produce positive returns under a variety of market conditions.

This has been demonstrated by, among others, Amin and Kat (2003), Fung and Hsieh (1999), Agarwal and Naik (2004), and Schneeweis and Martin (2001) at various times and using different hedge fund databases.

The decision investors now face is no longer whether to include this asset class to enhance the performance of traditional portfolios, but rather what is the most effective manner of incorporating it.

Investors wishing to commit themselves to hedge funds are faced with a dilemma. On the one hand, funds of hedge funds (FoFs) are the safest and simplest way to invest in hedge funds, because the FoF manager performs the due diligence, regular monitoring and performance evaluation of the individual funds on behalf of investors, including collection of monthly return and NAV information. Moreover, FoFs produce returns that are usually less volatile than those of individual hedge funds.

On the other hand, investors pay a premium for the safety and benefits of FoFs, in terms of the extra layer of fees charged by the FoF manager, which can be substantial. To further complicate matters, Brown, Goetzmann and Liang (2005) show that the triggering of incentive fees and high water marks of FoFs can vary depending on when investors enter the FoF.

FOF ALTERNATIVES

The alternative to investing in an FoF is to select a small pool of individual funds that will provide similar characteristics to large FoFs.

Of course, investors adopting this strategy will need to perform the due diligence and regular monitoring of the individual hedge funds. However, for institutional investors willing to commit large amounts of capital to hedge funds, these costs would be small compared with the extra layer of fees charged by FoFs.

By limiting our analysis to the largest funds, we are focusing on the funds which have some of longest track records and for which due diligence is, on average, easier to perform.

THE HEDGING STRATEGY

We propose a simple strategy to construct portfolios of hedge funds whose risk / return characteristics dominate those of FoFs.

Considering that any reasonable contender of funds of funds portfolios would argue that these vehicles offer a trade-off between absolute abnormal performance and risk exposures, one has to be careful in defining the notion of domination in performance. Should it be a model-free performance measure that is widely accepted by financial practice? In this case, the Sharpe ratio is a relevant benchmark.

If one considers an absolute percentage return obtained in addition to the required return on the financial markets, then one would consider the alpha, measured against a properly designed returns-generating model, as adequate performance metrics. But many practitioners would argue that the real skill of the fund manager should be measured with regard to the additional residual risk that is accepted to bear: the information ratio is then the relevant measure to use.

As a matter of fact, one could argue that different classes of hedge funds would exhibit different levels of comparative advantages with regard to each of these performance measures, but none should be able to dominate the others.

PORTFOLIO PERFORMANCE

The portfolios we construct contain a maximum of four hedge funds, equally weighted in the portfolio, allowing individual investors to adopt our methodology. The information used for fund selection is restricted to size and past performance.

We observe that a strategy that selects the best non-directional funds is very likely to dominate portfolios of funds of funds on all three performance measures.

The portfolios display a significant amount of persistence when performance is measured with the Sharpe ratio or the information ratio. This makes the portfolios attractive alternatives to FoFs, which only show persistence in alphas, but without sufficient performance levels to compare favourably with the best hedge funds portfolios.

The large risk exposure of directional hedge fund strategies does not make them likely to dominate FoFs, even in combination with non-directional hedge funds.