EVALUATING HEDGE FUND INVESTMENTS: THE ROLE OF PURE STYLE INDICES
Lhabitant joins the quest for a sound method to use in evaluating risk in portfolios of funds. He finds attractive the use of a small number of risk drivers (“factors”) in order to reduce the complexity of the task. Like other authors he proposes a linear factor model (a linear regression) to identify the risk drivers. Since there is ample research demonstrating that hedge fund returns have option-like (i.e., nonlinear) features, he proposes using as candidate factors, variables that are known to be nonlinear functions of more primitive risks. The natural set of candidates then are hedge fund style indexes.
Lhabitant then illustrates how this estimation approach can be used to compare a hedge fund’s stated approach to the styles that actually explain the fund’s returns. This technique might also be useful for evaluating style drift, a risk which is particularly difficult to monitor for hedge fund investors. This approach also suggests which index benchmarks might be most useful for evaluating performance. Finally, this approach provides a coarse means for an investor to establish (or verify) that their hedge fund portfolio effectively contains a diversified set of styles.
Lhabitant suggests that VaR could be calculated for any fund or portfolio of hedge funds even without the benefit of obtaining position information from the managers. First the VaR of each of the style factor indexes is calculated. The fund VaR is composed of two (appropriately combined) elements. The first element is in effect the VaR of a portfolio of style indexes, with weights provided by the funds betas with respect to each style. The second element is the VaR of the fund variance that is unexplained by the style factors.
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- Amenc, N., and Martellini L., 2002a, "The Brave New World of Hedge Fund Indexes", Working Paper, Edhec/Misys multi-style/multi-class research program.
- Amenc, N., and Martellini L., 2004, “Evidence of Predictability in Hedge Fund Returns and Multi-Style Multi-Class Tactical Style Allocation Decisions," Financial Analysts Journal
- Agarwal, V. and N.Y. Naik, 2000, ?Performance Evaluation of Hedge Funds with Option-based and Buy-and-Hold Strategies", WP HF-003, London Business School.
- Capital Market Risk Advisors 2000, “Hedge Fund Survey: Risk Management Overview”, Journal of Alternative Investments, 3 (2), 7-19.
- Fung, W., and Hsieh D., 1997, "Empirical Characteristics of Dynamic Trading Strategies", Review of Financial Studies, 10, pp. 275-302.
- Fung, W. and Hsieh, D. A., 2001, "Asset-based Hedge-Fund Styles and Portfolio Diversification," working paper.
- Lhabitant, F., 2001, "Hedge Fund Investing: A Quantitative Look Inside the Black Box", Journal of Financial Transformation 1, pp. 82-90.
- Lhabitant, F.S., 2001, "Assessing Market Risk for Hedge Funds and Hedge Funds Portfolios", Journal of Risk Finance, Spring, 1-17.
- Sharpe, W. F., 1992, "Asset Allocation: Management Style and Performance Measurement", Journal of Portfolio Management, 18), 7-19.
- Sharpe W. F., 1988, “Determining a Fund's Effective Asset Mix”, Investment Management Review, 2 (6), December, pp. 59-69.
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ERRATA AND OTHER MATERIAL
- Other research by Francois Serge Lhabitant:
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