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Abstract
What is the appropriate level of portfolio allocation towards fund of hedge
or 10%, fund of hedge funds being the satellite allocation. The core allocation
like equity and bonds. The core-satellite approach, however, is patently absurd
The aim of this article is two-folded. Firstly, we unveil the beta exposure of
fund of hedge funds with the application of a standard linear replication model.
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What is the appropriate level of portfolio allocation towards hedge funds?
Many would give a number around 5% or 10%. The rational for this number
often steams from the core-satellite approach. This advocates that the core
equity and bond exposures. The satellite is the allocation given to actively
managed funds (e.g. hedge funds) which will ideally add uncorrelated and
is the beta allocation and the satellite is the alpha allocation. Fund of hedge
funds (hereafter fund of funds) with their claim of absolute returns naturally
linear replication model, we rst aim to unveil the beta exposure of fund
investigate what the role fund of funds should then be in an investor's portfolio.
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vehicle asset managers' use to access hedge funds . Few investors indeed dare
to pick their own hedge fund managers and quite often rely on the services of
Several articles, e.g. Fung and Hsieh [2004] and Ennis and Sebastian [2003],
have provided evidence that fund of funds are exposed to a limited set of
market factors. Building on this other articles as Jaeger and Wagner [2005] and
portfolios which aim to replicate hedge fund returns. These latter portfolios
give a benchmark to fund of funds return and also give us a rough idea of
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the beta exposure of fund of funds. This is where we begin to unveil the beta
regression model and follows to a large extent previous work in the eld. The
over the sample period. The portfolio weights are estimated on a 24 month
analysis (SSA) model. The portfolio is then held over the consecutive month
K
X
rt = wi fi,t + λt (1)
i=1
K
X
s.t. wi = 1 (2)
i=1
factors, wi is the factor exposure towards the monthly return from factor fi,t ,
and λt is the part of the monthly returns, unexplained by the factors. The
model this model allows for short-selling since it falls more in line with hedge
funds strategies. Hedge funds report their monthly returns to data vendors
with some weeks delay. To account for this we lag the in-sample data one
2
month .
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clone to yield an approximately equal volatility as its fund of funds. The
leverage factor, denoted γt , is simply the volatility of the fund of funds divided
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by the volatility of the clone estimated on an ex ante basis .
and than almost to a fault a plain vanilla type of factor. The set of factors is
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more precisely :
BXM and RSL2000 are supposed to capture US large and small-cap eq-
uity exposure, and EAFE captures equity exposure towards some parts of the
We have not included any credit, duration or forex factors since these dier
somewhat from the factors in the list above. These factors are constructed by a
long and short position in two dierent securities, often with the net investment
being zero. It is then not to be expected that these factors are leveraged in
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is therefore required to include these factors. Excluding these, however, from
the clone portfolio should rather bias the performance downward than upward.
appropriate.
The hedge fund data sample we use is collected from the Hedge Fund
Research (HFR) database over the period January 1990 to December 2008.
funds are ltered out from the sample based on the criteria that they have to
be denominated in USD, report returns net of all fees, report AUM, and have
a track record which is longer than or equal to 37 month. For funds with the
same share class, the one with the longest history or domiciled in the US is
bias. While acknowledging this, the main objective is to study the relative
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performance of clones and fund of funds. As documented by among others
Fung and Hsieh [2000] and Liang [2000] the biases tend to introduce an upward
bias on average returns, which should imply that the linear replication model
is up for a more dicult task. Again, the objective of the article is to study
the relative performance between fund of funds and linear clones thus these
which invest in low volatility strategies as equity market neutral, xed income
managed futures funds. Strategic is the most volatile category and is primarily
exposed towards emerging markets, sector specic, and equity hedge funds.
and de Roon [2004], the constraint in (2) will give biased estimations of the
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weights .
the portfolio weights to only increase (decrease) the weight(s) to the factor(s)
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with the lowest (highest) variance (and covariance). Thus creating a portfolio
with lower risk than if the estimates from linear regression were to be used
Table 2 give some empirical evidence of this. The table presents the es-
variable is the HFRI fund of fund index which is explained by the previously
dened set of factors. For three of the factors the weights/exposures are similar
in magnitude. However for the two factors with the lowest volatility, BOND
and BMX, the weights and exposures from the two models varies signicantly.
Particularly for the BOND factor where the exposure is 0.26 but the weight is
Table 2 SSA vs. classic regression on the HFRI fund of funds index. (January 1990
December 2008)
Clone performance
Given the simplicity of the replication model, the vanilla-style factors, and bi-
ased estimation of weights we conjecture that clones capture the trend rather
erties of a basket of clones since large idiosyncratic deviations will cancel out.
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Table 3 Equal-weighted portfolios performance. (February 1992December 2008)
Performance summary
Annualized Monthly basis
Mean S.D. Sharpe VaRM5% ESM5% Min Max Median Kurt. Skew. ρ1 ρ2 TE
Funds 0.072 0.051 1.42 1.7 3.2 −6.0 5.1 0.7 7 −1 39.5∗ 23.5∗
All funds
Clones 0.062 0.073 0.84 3.1 5.0 −11.1 4.9 0.7 9 −1 16.2∗ −2.9 1.46
Funds 0.059 0.033 1.82 1.2 2.4 −5.2 2.5 0.7 16 −3 56.2∗ 37.4∗
Conservative
Clones 0.043 0.047 0.93 1.6 3.2 −8.1 4.7 0.5 17 −2 22.9∗ −4.5 1.12
Funds 0.072 0.052 1.40 2.0 3.4 −6.3 5.2 0.7 7 −1 37.7∗ 24.1∗
Diversied
Clones 0.065 0.074 0.88 2.9 5.0 −10.6 5.2 0.7 8 −1 14.3∗ −4.2 1.62
Funds 0.087 0.048 1.81 1.6 2.0 −2.6 4.4 0.8 3 0 1.6 −11.8
Market Defensive
Clones 0.068 0.081 0.84 2.9 5.6 −10.8 5.8 0.7 8 −1 18.3∗ 11.6 2.32
Funds 0.088 0.081 1.09 2.7 4.5 −8.4 9.1 0.8 6 0 36.8∗ 18.3∗
Strategic
Clones 0.084 0.118 0.71 5.4 7.7 −14.0 9.7 1.0 5 −1 11.4 −5.8 2.95
Funds 53 49 59 59 34 21 4 −40 89 97 90 95 61 93
All funds
Clones 69 67 66 65 39 57 −23 −58 69 63 60 59 28 63
Funds 49 50 49 54 40 19 −3 −37 75 84 90 80 47 77
Conservative
Clones 57 58 47 56 37 67 −28 −53 53 52 54 48 25 48
Funds 52 48 57 57 33 25 4 −39 88 97 90 94 62 92
Diversied
Clones 68 66 66 63 38 58 −22 −57 70 63 59 59 30 63
Funds 0 −4 9 16 21 30 −16 −2 31 45 38 43 85 34
Market Defensive
Clones 31 30 23 37 43 65 −21 −36 40 48 53 44 30 42
Funds 51 46 60 56 27 13 12 −38 88 94 82 92 55 94
Strategic
Clones 69 66 69 64 34 44 −22 −55 68 58 53 54 22 61
In this section we have constructed equal-weighted, monthly re-balanced,
portfolios of funds of funds and of the replication solutions, based on either the
distributional return properties of the linear clones are impressive. The return
1% on an annualized basis. Yet with a higher volatility for the former, which
The level of tracking error (TE) between clone and fund of funds portfolios
indicate that any précis time-series properties are not captured by the linear
vs. linear clones in a portfolio context. Thus the level of tracking error is not
our greatest concern but rather that the general return distributions can be
folios of clone, and fund of funds, and the S&P 500 index. The clone portfolio
seems to track the fund of funds portfolio fairly well and both has markedly
Turning to the lower panel in table 3, fund of funds and clone portfolios
bias the portfolio towards low-risk assets explains the large dierence in bond
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Figure 1 Cumulative returns of clones and fund of funds.
towards the HFRI indices are lower for clone portfolios than fund of funds
portfolios.
light of the characteristic of the style. Market Defensive fund of funds are
focused on CTA and short biased hedge funds. The managed futures group of
respective factors over the full sample period. There is little variation between
BOND. Any concerns that clone returns are due to leveraging are refuted by
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Table 4 Portfolio allocation statistics. (%)
Turn
BXM RSL2000 EAFE CMDTY BOND Lvrg. over
All clones 25 7 10 4 54 100 9
Std. (21) (7) (12) (7) (18) (16) (8)
Diversied 24 8 10 4 54 102 9
(20) (7) (12) (8) (19) (17) (8)
Strategic 20 14 17 2 47 136 20
(28) (12) (17) (16) (25) (42) (26)
the second, last column in table 4 which indicate low and often less than 100%
leverage levels. The last column presents the annual turnover rate which is
within a modest range. While this article do not account for trading cost, the
low turnover rate reassures that this should only have modest impact of the
clone performance.
of clones of the Conservative fund of funds was only leveraged to around 70%.
Given the setting this implies that 30 % of the portfolio capital is held in cash
with no returns, which is not a plausible scenario. While the cost of leveraging
is neither accounted for, this is easily accessible at a low cost through margin
accounts.
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Treasury bill rate . This increases the performance of the equal-weighted
clone portfolio of the Conservative style and puts it at par with its respective
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fund of funds portfolio, only diering with a few basis points annually. On
the other hand it does modestly lower the returns of the other equal-weighted
clone portfolios, in particular the Market Defensive and the Strategic style
The issue of including or excluding the Treasury bill rate as cost of leverage
brings us to another previously discussed topic of the set of factors which we use
to replicate the fund of funds. In our study we have chosen a broad, vanilla
style, and liquid set of factors. However this have come at the drawback
using the same set of factors and including the 3-month Treasury bill rate.
explicitly in the set of factors improves the relative and absolute performance
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of the Conservative clone equal-weighted signicantly . This highlights the
To conclude this section; keeping in mind the low turnover rate and the
vanilla type of factors, the model allows us to capture large parts of hedge
exposed to bond, equity and commodity risk. Even more, these extracted
exposures are able to fairly well replicate the average performance of fund of
funds. This poses some serious questions on which role fund of funds can play
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in the investor's portfolio.
cation:
Asset Allocation
S&P 500 40%
EAFE 20%
BOND 40%
Sharpe (Annual) 0.62
The essence of this last portfolio is to extract the return of fund of funds
that cannot be attributed to general market risk premiums, and often referred
to as alpha returns.
mentioned before linear clones seem to be good at capturing the return trend of
fund of funds rather than a precise replication of each fund of funds. We would
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clone and fund of funds allocation as we describe it here should give good
We will test whether or not our three alternative portfolios should be in-
cluded to the strategic asset allocation decision process, based on the mean-
mark. Britton-Jones [1999] highlights the impact of sampling errors when es-
1 = Rw + e. (3)
zero variance and positive constant returns. The objective of the OLS min-
Britton-Jones show in more detail that the OLS estimate of the factor loadings
in this order is that the estimated weight ŵi has a t distribution under the
Table 5 presents the scaled (i.e. w̄i = ŵi /ŵ0 1) weights from the regression
in (3) and the associated standard errors (S.E.) and t-statistics. The rst and
second column presents the results with the fund of funds or clones portfolio
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Table 5 Britton-Jones (1999) test of portfolio weights. (February 1992December 2008)
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as the Alternative Portfolio. Weights are similar between these groups where
allocation is close to 100% for the Alternative Portfolio and consequently close
most pronounced for the Strategic and Market Defensive, which is expected
from previous analysis. The hypothesis that the weight of the Traditional
folio, cannot be rejected at the 95% in any of the sample groups. The size
the anity between linear clones and their respective fund of funds. The null
hypothesis of zero weights is rejected on the 99% level for fund of funds across
all styles. The signicance level to reject the null hypothesis is equally high
for most clone portfolio weights, except for the aggregate of all clones which
have a 95% signicance level and the Strategic which is not signicant.
ing a portfolio of traditional assets, fund of funds and clones seems to replace
in the clones) that there is no need to keep the traditional long-only portfolio.
This conrms the result of the previous section. This also in contrast to the of-
ten used, and advocated approach, to include hedge fund investment through a
5%.
The results in table 5 for the Alpha Portfolio shows that the t-statistics
in most cases reject any of the hypothesis that the weight of the Traditional
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Portfolio or the Alpha Portfolio should be equal to 0. The sizes of the mean-
variance ecient weights are also dierent from before, where the size of the
The lower levels of Sharpe ratio for the clone portfolios relative to the fund
of funds portfolios goes in line with the ndings of the previous section. There
is a notable similarity of the level of Sharpe ratio between Alpha Portfolios and
fund of funds portfolios. Again, this stress that if the beta exposure of fund
of funds are not hedged, there is no need to give allocation to the long-only
Traditional Portfolio. At the same time, hedging the beta exposure seems to
Conclusion
The empirical results in this article suggest that linear fund of funds clones to
a large degree are interchangeable with its constituent fund of funds in an asset
allocation context. The pressing question is then why this is the case? The
answer is in the pudding, we believe. After fees, fund of funds in aggregate are
risk exposure.
and they also give information to the allocation and market risks of fund
of funds. This transparency given by clones, and the results from the last
considered as a satellite asset. Given our results, it falls more natural to only
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give allocation to the fund of funds; if not the market risk is hedged. Yet it has
opacity, and large fees associated with fund of funds investment. The two rst
This suggests that funds of funds on aggregate do not contribute with new
exposure. This is by itself either a strong argument against the prevailing asset
allocation idea that fund of funds should only be given a marginal allocation or
a clear indication that fund of funds on average do not expose their investors
Endnotes
1 According to Hedge Fund Research Industry Report Q2-2008 the fund of funds
managed in aggregate 43% of all hedge fund assets.
2 I.e. at time t we estimate portfolio weights using data over [t − 25, t − 1]
√P
3 More precisely γ := σ = q , where σr is the volatility of the
25 2
rt k=2(r −r̄ ) /23
t−k t
t σ∗ 25 ∗ 2 t
rt
(r −r̄ ) /23
∗
P
4 All the data for these factors are downloaded from Datastream.
5 It is often incorrectly assumed that the exclusion of the intercept in SSA have a
big impact on the estimation process as compared to linear regression. Omitting the
intercept does in fact not change the solution at all, see Becker [2003]
6 These results are available on request.
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References
[1] T. Becker. Exploring the mathematical basis of return-based style analysis.
[4] W. Fung and D.A. Hsieh. Performance characteristics of hedge funds and
[7] B. Liang. Hedge funds: The living and the dead. Journal of Financial and
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