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Funds of Hedge Funds

Performance, Assessment, Diversification, and Statistical Properties

1st Edition - July 18, 2006

Author: Greg N. Gregoriou

Hardback ISBN:

9 7 8 - 0 - 7 5 0 6 - 7 9 8 4 - 8

eBook ISBN:

9 7 8 - 0 - 0 8 - 0 4 7 2 8 2 - 9

With about $450 billion in assets, funds of hedge funds are the most recent darling of investors. While hedge funds carry high risk for the promise of high returns they are… Read more

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With about $450 billion in assets, funds of hedge funds are the most recent darling of investors. While hedge funds carry high risk for the promise of high returns they are designed for the very rich and for large institutional investors such as pension funds. A Fund of Hedge Funds (FOF) spreads investments among a number of hedge funds to reduce risk and provide diversification, while maintaining the potential for higher than average returns. Odds are that some pension fund of yours is invested heavily in these products, and more recently these FOFs have been opened to more and more individual investors in offshore jurisdictions with lower minimum entry levels. Since this is a new and extremely fast-moving financial phenomenon, academic research has just begun in earnest, and this is the first book to present rigorous academic research by some of the leading lights in academic finance, carefully analyzing the broad array of issues involved in FOFs.

Preface and AcknowledgmentsAbout the editorList of contributorsPart One Performance1 Rank alpha funds of hedge funds Carol Alexander and Anca Dimitriu1.1 Introduction1.2 Hedge fund data and biases1.3 Factor models for hedge funds1.4 Model estimation1.5 Rank alpha1.6 Optimising funds of hedge funds1.7 Cleaning the covariance matrix1.8 Performance analysis of rank alpha portfolios 1.9 ConclusionReferences2 Funds of hedge funds: bias and persistence in returnsDaniel Capocci and Georgers Hübner2.1 Introduction2.2 Database2.3 Methodology2.4 Descriptive statistics 2.5.1 Bias analysis 2.5.2 Survivorship bias2.5.3 Instant return history bias2.6 Persistence in performance 2.6.1 Persistence in performance based on past performance2.6.2 Persistence in performance based on past risk measures2.7 ConclusionReferences 3 Replication and evaluation of fund of funds returns 1994-2005Harry M. Kat and Helder P. Palaro3.1 Introduction3.2 The KP efficiency measure 3.3 Evaluation results3.4 Distributional analysis3.5 ConclusionReferences4 Factor decomposition of fund of funds returnsJean-François Bacmann, Pierre Jeanneret, and Stefan Scholz 4.1 Introduction4.2 Experimental framework 4.3 Factor model for fund of funds4.4 Sample formation4.5 Performance decomposition of FOF portfolios4.6 Principal components of FOF returns4.7 ConclusionReferences5 Optimal fund of fund asset allocation: hedge funds, CTAs and REITs Nicolas Papageorgiou and Alain Elkaim5.1 Introduction5.2 Data5.3 The methodology5.4 Results5.5 ConclusionReferences6 The changing performance and factor risks of fund of funds in the modern period Keith H. Black6.1 Characteristics of funds of funds6.2 Comparing returns: funds of funds vs. hedge funds6.3 Ancient history vs. modern history: LTCM as the defining moment6.4 Factor analysis of returns6.5 The future of funds of fundsReferences 7 Hedge fund indices: are they cost-effective alternatives to fund of funds?Kathryn Wilkens7.1 Introduction7.2 Fund of funds7.3 Investable hedge fund indices7.4 Distribution of returns and potential biases7.5 Asset based style factors7.6 Mean excess return and Sharpe ratio comparisons7.7 Fung and Hsieh model alphas and information ratio comparisons7.8 Correlation with traditional asset returns and lagged equity return comparisons7.9 ConclusionReferences8 Simple hedge fund strategies as an alternative to funds of funds: evidence from large cap funds Greg N. Gregoriou, Georges Hübner, Nicolas Papageorgiou, and Fabrice Rouah8.1 Introduction8.2 Data8.3 Methodology8.4 Empirical results8.5 ConclusionReferencesPart Two Diversification, Selection, Allocation and Hedge Fund Indices9 Funds of funds of hedge funds: welcome to diworsificationFrançois-Serge Lhabitant and Nicolas Laporte9.1 Introduction9.2 The art and science of diversification9.3 Analysis9.4 Diversification results9.5 How about the fees?9.6 ConclusionReferences 10 Style analysis of funds of hedge funds: measurement of asset allocation and style driftAndreas Oehler and Oliver A. Schwindler10.1 Introduction10.2 Sharpe’s model for style analysis10.3 Data set10.4 Hedge fund classification10.5 Accuracy of Sharpe’s model10.6 Measuring the style drift10.7 ConclusionReferences11 Gains from adding funds of hedge funds to portfolios of traditional assets: An international perspective Niclas Hagelin, Bengt Pramborg, and Fredrik Stenberg11.1 Introduction 11.2 Data 11.3 Method 11.4 Results11.5 Conclusion References12 Tactical asset allocation for hedge fund indices at one- to six-month horizonsLaurent Favre12.1 Introduction12.2 The Model12.3 The results12.4 ConclusionReferences13 Single strategy funds of hedge funds: how many funds?Ryan J. Davies, Harry M. Kat, and Sa Lu 13.1 Introduction13.2 Decomposition13.3 ConclusionReferences Part Three Construction, and Statistical Properties of Funds of Hedge Funds14 The distributional characteristics of fund of hedge fund returnsElaine Hutson, Margaret Lynch and Max Stevenson14.1 Introduction14.2 Hedge funds: background14.3 Testing for normality14.4 Data and summary performance information14.5 Results14.6 ConclusionReferences15 Funds of funds and diversification effect Maher Kooli15.1 Introduction15.2 Mean-variance spanning tests 15.3 Data description 15.4 Empirical results15.5 ConclusionReferences16 Higher-moment performance characteristics of funds of fundsZsolt Berenyi16.1 Introduction16.2 Performance assessment basics16.3 Data and methodology16.4 Performance characteristics of funds of funds16.5 Enhancing FOF performance16.6 Results 16.7 ConclusionReferences17 The market risk of funds of hedge funds: a conditional approach Florent Pochon and Jérôme Teïletche17.1 Introduction17.2 Implications for hedge funds returns modelling17.3 An application to stress testing 17.4 ConclusionReferences 18 Revisiting the Fama and French model: An application to funds of funds using nonlinear methodsEric Dubé, Clément Gignac and François Eric Racicot18.1 Introduction 18.2 Methodology18.3 Data18.4 Results18.5 ConclusionReferences19 Investor’s choice: an investor-driven, forward-looking optimization approach to fund of hedge fund constructionClemens H. Glaffig 19.1 Introduction19.2 The data set: defining market patterns19.3 The methodology: investor-driven objectives and the optimization algorithm19.4 Empirical analysis: exhibiting the new degrees of freedom19.5 ConclusionReferencePart Four Monitoring Risk, Overview of FOFs, Due Diligence, and Special Classes of Funds of Funds20 Moments analysis in risk and performance monitoring of funds of hedge funds David K.C. Lee, Kok Fai Phoon, and Choon Yuan Wong20.1 Introduction20.2 Funds of hedge funds20.3 Investing in funds of hedge funds – a practical approach20.4 Data description, empirical analysis and results20.5 Analysis of trade-off20.6 ConclusionReferences21 An overview of funds of hedge fundsJean Brunel21.1 Introduction 21.2 Creating a portfolio of hedge funds21.3 Ongoing portfolio management21.4 Returning to the problem of the individual investor21.5 Tracking funds of funds21.6 ConclusionReferences22 Institutional investment due diligence on funds of hedge funds John E. Dunn, III22.1 Introduction22.2 The gap: fiduciary responsible investing vs. private client products22.3 Exploring institutional fiduciary responsibility22.4 Exploring fiduciary responsibility: what IBM has that the average hedge fund of fund needs to incorporate22.5 ConclusionReferences23 Synthetic CDO squares and the continuing evolution of funds of funds Paul Ali23.1 Introduction23.2 Development of synthetic CDO squares 23.3 Structure of synthetic CDO squares 23.4 Recharacterisation risk 23.5 Conclusion References24 Natural resources fund of funds: essays on active management, risk management, and due diligenceRian Akey, Hilary Till, and Aleks Kins 24.1 Introduction24.2 Emerging demand for natural-resources investments 24.3 Diversified, active-management opportunities in natural-resources investing 24.4 Risk management in natural-resources futures trading 24.5 Due diligence in natural-resources fund of fund investing 24.6 Conclusion References25 Identifying and monitoring risk in a fund of hedge funds portfolioMeredith A. Jones25.1 Introduction25.2 Diversification and over-diversification25.3 Liquidity25.4 Transparency25.5 Factor and impact analysis25.6 ConclusionReferences 26 The wizardry of analytics for funds of fundsMary Fjelstad and Leola Ross 26.1 If I only had good risk analytics...26.2 You’re not in Kansas anymore26.3 Click your heels and say “There’s nothing like diversification…”26.4 We’re off to see the wizard…26.5 The man behind the curtain26.6 Follow the yellow brick road…26.7 You’re never going back to Kansas27 Quantitative hedge fund selection for fund of fundsStephan Joehri and Markus Leippold27.1 Introduction27.2 Indicators for hedge fund selection27.3 Data27.4 Empirical results27.5 ConclusionReferences

Greg N. Gregoriou

A native of Montreal, Professor Greg N. Gregoriou obtained his joint Ph.D. in finance at the University of Quebec at Montreal which merges the resources of Montreal's four major universities McGill, Concordia, UQAM and HEC. Professor Gregoriou is Professor of Finance at State University of New York (Plattsburgh) and has taught a variety of finance courses such as Alternative Investments, International Finance, Money and Capital Markets, Portfolio Management, and Corporate Finance. He has also lectured at the University of Vermont, Universidad de Navarra and at the University of Quebec at Montreal.

Professor Gregoriou has published 50 books, 65 refereed publications in peer-reviewed journals and 24 book chapters since his arrival at SUNY Plattsburgh in August 2003. Professor Gregoriou's books have been published by McGraw-Hill, John Wiley & Sons, Elsevier-Butterworth/Heinemann, Taylor and Francis/CRC Press, Palgrave-MacMillan and Risk Books. Four of his books have been translated into Chinese and Russian. His academic articles have appeared in well-known peer-reviewed journals such as the Review of Asset Pricing Studies, Journal of Portfolio Management, Journal of Futures Markets, European Journal of Operational Research, Annals of Operations Research, Computers and Operations Research, etc.

Professor Gregoriou is the derivatives editor and editorial board member for the Journal of Asset Management as well as editorial board member for the Journal of Wealth Management, the Journal of Risk Management in Financial Institutions, Market Integrity, IEB International Journal of Finance, and the Brazilian Business Review. Professor Gregoriou's interests focus on hedge funds, funds of funds, commodity trading advisors, managed futures, venture capital and private equity. He has also been quoted several times in the New York Times, Barron's, the Financial Times of London, Le Temps (Geneva), Les Echos (Paris) and L'Observateur de Monaco. He has done consulting work for numerous clients and investment firms in Montreal. He is a part-time lecturer in finance at McGill University, an advisory member of the Markets and Services Research Centre at Edith Cowan University in Joondalup (Australia), a senior advisor to the Ferrell Asset Management Group in Singapore and a research associate with the University of Quebec at Montreal's CDP Capital Chair in Portfolio Management. He is on the advisory board of the Research Center for Operations and Productivity Management at the University of Science and Technology (Management School) in Hefei, Anhui, China.

Affiliations and expertise

School of Business and Economics, State University of New York, Plattsburgh, NY, USA