Funds of Hedge Funds

Performance, Assessment, Diversification, and Statistical Properties


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

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.
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Primary audience: Researchers and academics in Finance.


Book information

  • Published: July 2006
  • ISBN: 978-0-7506-7984-8


"Want to learn all about hedge funds and funds of hedge funds and sift out the truth from the misconceptions? Then read this comprehensive assessment of the field. It goes from A to Z in coverage and together all the papers provide a good course in this fast growing and controversial subject." -- William T. Ziemba, Alumni Professor of Financial Modeling and Stochastic Optimization (Emeritus), Sauder School of Business, University of British Columbia "Funds of hedge funds are fast emerging as one of the most popular alternative investment vehicles offering diversification, access to hedge funds that are closed for new investment, and due diligence. This great collection of research articles on funds of hedge funds will surely inform the readers about the pros and cons associated with investing in funds of hedge funds." -- Vikas Agarwal, Assistant Professor of Finance, J. Mack Robinson College of Business, Georgia State University "The international demand for hedge funds from institutional investors is gaining more and more momentum. As most of this growth can be attributed to funds of hedge funds, this excellent new edited book couldn’t be more timely. Again, the editor has done an outstanding job of gathering contributions of great academic and practical use from some of the leading authorities in this area often considered as opaque. Fund of Hedge Funds is the definitive source of information for industry professionals, institutional investors and academics alike. A more comprehensive analysis of the Performance, Application and Risk Management of fund of hedge funds is hard to come by." -- Dieter G. Kaiser, Institutional Research, Benchmark Alternative Strategies GmbH "According to TASS Tremont, the fraction of hedge funds that are funds of funds has doubled over the past five years, to 28 percent of all hedge funds as of September 2005. Attention must be paid. Academics have only just recently started to become interested in this business. This book of readings is one the first published collections of original scholarly papers on this subject. It is of great interest to many academics as well as of course to the many practitioners who are in the business today or who would very much like to enter the fund of funds business." -- Stephen J. Brown, David Loeb Professor of Finance, NYU Stern School of Business

Table of Contents

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