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Hedge Fund Diversification: The good, the bad and the ugly

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Hedge Fund Diversification: The good, the bad and the ugly Michelle Learned Banque Syz (3A) Fran ois-Serge Lhabitant Edhec et HEC Universit de Lausanne – PowerPoint PPT presentation

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Title: Hedge Fund Diversification: The good, the bad and the ugly


1
Hedge 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

2
Agenda
  • Introduction
  • Our approach of hedge fund diversification
  • Empirical results
  • Conclusion

3
Growth of hedge funds
4
Growth of hedge funds
5
Improving the Efficient Frontier
6
Return and Volatility
7
Return and Max Drawdown
8
Riskier than traditional investments?
MSCI World
Asia Crisis (8/97)
Iraq Crisis (8/90)
September 11 (9/01)
Russia Crisis (8/98)
9
How 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?

10
How 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
11
Naive 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!

12
Formulation 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
13
Methodology
  • 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.

14
Returns, 1998-2001
15
Volatility, 1998-2001
16
Volatility, 1998-2001
17
Skewness, 1998-2001
18
Kurtosis, 1998-2001
19
Worst Monthly Return, 1998-2001
20
VaR (95, 1M) , 1998-2001
21
VaR (95, 1M), 1998-2001
22
Max. Drawdown, 1998-2001
23
Correlation with SP 500, 1998-2001
24
Correlation to Tremont Indices, 1998-2001
25
Some 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.

26
Smart Diversification
27
Smart Diversification
28
Conclusions
  • 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?
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