Title: Hedge Fund Diversification: The good, the bad and the ugly
1Hedge Fund Diversification The good, the bad
and the ugly
- Michelle Learned
- Banque Syz (3A)
- François-Serge Lhabitant
- Edhec et HEC Université de Lausanne
- Contact francois_at_lhabitant.net
2Agenda
- Introduction
- Our approach of hedge fund diversification
- Empirical results
- Conclusion
3Growth of hedge funds
4Growth of hedge funds
5Improving the Efficient Frontier
6Return and Volatility
7Return and Max Drawdown
8Riskier than traditional investments?
MSCI World
Asia Crisis (8/97)
Iraq Crisis (8/90)
September 11 (9/01)
Russia Crisis (8/98)
9How to Invest into Hedge Funds?
- Diversification seems to be the rule.
- It reduces the impact of selecting a bad manager.
- Low correlation between managers supports the
idea of diversifying. - In practice,
- There are very few index products.
- Dedicated hedge fund portfolio.
- Fund of hedge funds.
- The new questions
- What is the optimal number of hedge funds in a
portfolio? - What is the maginal impact of adding a new hedge
fund in an existing hedge fund portfolio?
10How many assets/funds?
- How many assets make a diversified portfolio?
- Evans and Archer (1968) 8 to 10.
- Statman (1987) 30 to 40.
- How about hedge funds?
- Billingsley and Chance (1996) for managed
futures. - Henker and Martin (1998) for CTAs.
- Henker (1998) for hedge funds.
- Amin and Kat (2000)
- Ruddick (2002)
8 to 10
at least 20
11Naive Diversification for Hedge Funds
- Naive diversification is better for HF than
Markowitz optimisation. - Non normality of returns is ignored by
mean-variance optimisers. - Optimisers need good forecasts of expected return
and expected risk. - Operational difficulties, e.g. lockup clauses,
minimum investments, exit notifications, etc. - A recent survey by Arthur Andersen (2002) of
Swiss hedge fund investors and fund of hedge
funds managers confirms our intuition. It appears
that most participants do not use a quantitative
approach for their asset allocation strategy.
Many respondents even admitted to having no asset
allocation strategy at all!
12Formulation of asset allocation strategy by
financial intermediaries using hedge funds
Advisors
Banks
12
13
quantitative model
21
13
quantitative
25
62
model
13
41
no asset allocation strategy
no asset allocation strategy
Many hedge fund services suppliers do not have an
asset allocation strategy
13Methodology
- Database
- 6,985 distinct hedge funds, including dead funds.
- Sources public databases data from
administrators and managers - Monte-Carlo simulation
- We create equally weighted portfolios of
increasing size (N1, 2, 50) by randomly
selecting hedge funds from our data (no
replacement). - For each portfolio size, this process is repeated
1,000 times to obtain 1,000 observations of each
statistic.
14Returns, 1998-2001
15Volatility, 1998-2001
16Volatility, 1998-2001
17Skewness, 1998-2001
18Kurtosis, 1998-2001
19Worst Monthly Return, 1998-2001
20VaR (95, 1M) , 1998-2001
21VaR (95, 1M), 1998-2001
22Max. Drawdown, 1998-2001
23Correlation with SP 500, 1998-2001
24Correlation to Tremont Indices, 1998-2001
25Some Variations
- We repeated the experiment for the 1990-1993 and
1994-1997 periods. - Findings are similar, although the level of risk
seems to have increased over the years. - We repeated the experiment using only surviving
funds. - Findings are similar, although the level of risk
is lower. - It seems that most funds that disappeared did it
for performance reasons. - We repeated the experiment using a smarter
diversification technique, based on the
self-attributed classification of the funds.
26Smart Diversification
27Smart Diversification
28Conclusions
- Diversification (naive or smart) is clearly a
protection against ignorance. - Diversification brings most of its benefits
already with very few funds in a portfolio. - Funds of hedge funds seem overdiversified, at
least from a market risk perspective. - How about time?