One of the main reasons that institutional investors include hedge funds in their portfolios is the expected diversification benefits with existing array of investment opportunities. In the U.S., institutions such as endowments and foundations are still increasing the allocation to hedge funds, despite the fact that hedge funds in general have underperformed in recent years. They seek top managers in this space and determine allocation in strategies and styles to best position themselves.
In order to set beta, manage beta, and manage alpha, hedge fund of funds managers typically use three allocation methods:
- Strategic allocation to various hedge fund strategies
- Tactical allocation across hedge fund strategies
- Dynamic allocation to individual manages
The most common methods for allocating across the strategies are:
- Equal weight − simply average the exposures across all of the underlying strategies
- Asset weight − assigns a weight to each strategy based upon the distribution of assets across strategies
- Subjective weight − relies on the forward-looking forecasts of strategists to determine the proper allocation, which requires a level of skill over time
- Optimized weight − uses a rules-based model to determine the allocation based on measurable metrics, e.g. a mean-variance optimization using inputs on estimated return, volatility, and correlation.
Convergent vs. Divergent
Theoretically, allocation in hedge funds strategies are grounded on two philosophies, either “convergent” or “divergent.” A convergent strategy is based on a security’s intrinsic value, so the strategy looks to undervalued or overvalued securities, whose prices are mismatched with their intrinsic values. By contrast, a divergent strategy believes that security return patterns reflect the changing attitudes of investors to a variety of economic, political, and psychological factors.
Specifically, a convergent strategist believes that supply and demand are determined by such factors as the growth rate in earnings and macroeconomic factors in the long run. In comparison, although divergent strategists recognize that intrinsic value plays a role in determining supply and demand, they argue that a wide range of irrational factors, e.g. emotions, govern the supply-demand relationship. Therefore, a divergent strategist may select a security even if it appears overvalued relative to its intrinsic value.
The conditions for achieving alpha from convergent strategy:
- The information generated by fundamental analysis predicts future economic variables that will eventually be priced by the market.
- The market temporarily under-utilizes the information in the fundamental signals about future economic variables.
- It is possible that not all investors have equal access to fundamental information (EMH), and therefore, some investors may miss out on major moves.
The conditions for achieving alpha from divergent strategy:
- If fundamental information is incomplete or misleading, e.g., misleading accounting information and SEC filings.
Previous empirical research suggests that divergent strategy experienced significantly higher performance during periods of increasing market uncertainty, and when combined with the convergent strategy, the resulting portfolio would most likely:
- Reduce the volatility of the individual strategy and increase the kurtosis of the return distribution;
- Reduce the negative outliers, shift the skewness to the positive side;
- Enhance returns in economic environments in which the convergent strategy alone offers limited return opportunities;
- Increase the risk-adjusted performance measures significantly, obtaining the maximum return/risk trade-off.
Portfolio Construction Methods
- Stratification – by mimicking the composition of a broad hedge fund index
- Mean-Variance Optimization – the benefits arise from low correlation among selected assets, and thus only three dimensions are considered, i.e. mean return, standard deviation, and correlation. However, due to the shortcomings of mean-variance optimization, many managers have attempted to better account for the specific risk features of hedge funds. They extend portfolio optimization techniques to account for the presence of fat-tailed distributions, mostly by introducing the VaR (Value-at-Risk) -related technique.
- Modified VaR Optimization – the method was designed with the attempt to quantify the risk of losses. By incorporating the expansion of VaR, Cornish-Fischer expansion, one can create the modified VaR, a tool which can measure risk based on all return factors. The portfolio is constructed by identifying the portfolio composition which has the lowest modified VaR for any given return.
Like allocation in any asset classes, diversification in hedge funds also seeks to invest in strategies which have a low correlation to each other, thereby maximizing the expected return under all market conditions:
- Core allocation
- Tactical allocation
- Geographical allocation
The optimal numbers of managers in a fund of funds portfolio:
In equity space, the optimal number of stock holdings in a portfolio is approximately 20; each additional stock would result in a loss in the true risk-reduction effect; similarly, in the hedge fund of funds world, a portfolio of around 15 funds is optimal for standard deviation reduction, but may also result in lower skewness and increased stock market correlation. A recent study suggests that the main culprits for the lower skewness in a hedge fund portfolio are the fixed income arbitrage and event driven strategies, but the optimal number of hedge fund managers to be included is also 15 – 20, as hedge fund of funds have the same liquidity and dis-economics of scale problems as equity funds.
Despite the benefits of hedge funds, a number of characteristics have limited average investors’ desire for them:
- Manager selection – not all can find the top manager, given different levels of due diligence can be performed
- Liquidity – hedge fund industry standards are to provide semi-liquidity with advance notice of up to 45 – 90 days
- Transparency – reporting requirements in the hedge fund industry are far more relaxed than for registered investment products
- Fees – hedge funds typically charge management fees of 100 – 200 basis points plus performance fees of 10 – 25% of the aggregate profits subject to high water mark. The fund of funds adds another layer of fees for their service such as manager selection and due diligence
- Hedge funds tend to have risks beyond volatility
- Taxes can erode hedge fund returns
Hedge fund of fund allocations using a convergent and divergent strategy approach – Sam Chung, Mark Rosenberg, and James F. Tomeo