Abstract
Funds of funds have gained in popularity over recent years. The use of hedge funds in a portfolio has also been shown to reduce its volatility. This chapter examines the monthly returns of funds of funds and of hedge funds for statistical differences between two periods, 1997 to date and 2001 to date. In doing so, it seeks to determine whether the tech crash has affected the management of funds of funds and hedge funds. It also tests for nonlinearity in series of hedge fund returns. The inquiry uses various simple asset pricing models, whose results show a presence of nonlinearity that in some cases significantly affects estimates of alphas. The data tends, in part and for certain funds, to discredit the simple market model and the three-factor model of Fama and French. In some cases, the use of these models induces bad specification because the omission of variables biases the results obtained. This could lead fund managers to choose the wrong hedge funds in constituting a fund of funds. In addition, managers could be under the impression they have reduced risk when they have in fact increased it.
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