8 - Simple hedge fund strategies as an alternative to funds of funds: Evidence from large-cap funds

Abstract

This chapter proposes a simple alternative to investing in funds of funds. In order to avoid a second layer of management and performance fees, it constructs simple equal-weighted portfolios of large-capitalization hedge funds whose performance characteristics dominate those of the largest funds of funds. The portfolios constructed contains a maximum of four hedge funds, equally weighted in the portfolio. The information used for fund selection is restricted to size and past performance. The performance of the two investment possibilities are compared by using three different measures, namely alpha, the Sharpe ratio, and the information ratio. The results demonstrate that there exists sufficient persistence in returns, especially for nondirectional strategies, which let these simple portfolios of hedge funds outperform the best funds of funds based on all three measures. The dominance holds for the total sample period but, more importantly, when the sample is split in two subperiods of equal length. The Sharpe ratio is the best measure for evaluate persistence from one period to the next and, to a lesser extent, the information ratio.