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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@lhabitant.net. Agenda. Introduction Our approach of hedge fund diversification Empirical results Conclusion.
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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@lhabitant.net
Agenda • Introduction • Our approach of hedge fund diversification • Empirical results • Conclusion
Equity Hedge Relative Value MSCI World Event Driven Riskier than traditional investments? MSCI World Asia Crisis (8/97) Iraq Crisis (8/90) September 11 (9/01) Russia Crisis (8/98)
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?
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
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!
mean-variance mean-variance- approach approach another approach another approach (qualitative) (qualitative) 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
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 (N=1, 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.
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.
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?
