Abstract
This article introduces a large scale simulation framework for evaluating hedge funds’ investments subject to the realistic constraints of institutional investors. The method is customizable to the preferences and constraints of individual investors, including investment objectives, performance benchmarks, rebalancing period and the desired number of funds in a portfolio and can incorporate a large number of portfolio construction and fund selection approaches. As a way to illustrate the methodology, we impose the framework on a subset of hedge funds in the managed futures space that contains 604 live and 1323 defunct funds over the period 1993–2014. We then measure the out-of-sample performance of three hypothetical risk-parity (RP) portfolios and two hypothetical minimum risk portfolios and their marginal contributions to a typical 60–40 portfolio of stocks and bonds. We find that an investment in managed futures improves an investor’s performance regardless of portfolio construction methodology and that equal risk approaches are superior to minimum risk portfolios across all performance metrics considered in the study. Our article is relevant for institutional investors in that it provides a robust and flexible framework for evaluating hedge fund investments given the specific preferences and constraints of individual investors.
Highlights
The hedge fund industry represented about US $3 trillion in assets under management (AUM) during the first quarter of 2015 according to the BarclayHedge Group
MBB apply a one-month lag parameter to account for the reporting delay, impose AUM and track record length requirements, and introduce a simulation framework that limits the number of funds within a portfolio and evaluate out-of-sample performance using a stochastic dominance framework
The framework is customizable to the preferences and constraints of individual investors regarding rebalancing periods and the desired number of funds in a portfolio and can incorporate a large number of portfolio construction and fund selection approaches
Summary
The hedge fund industry represented about US $3 trillion in assets under management (AUM) during the first quarter of 2015 according to the BarclayHedge Group. MBB apply a one-month lag parameter to account for the reporting delay, impose AUM and track record length requirements, and introduce a simulation framework that limits the number of funds within a portfolio and evaluate out-of-sample performance using a stochastic dominance framework. For the out-of-sample period between January 1999 and December 2014, a 10 per cent allocation to managed futures improves the Sharpe ratio of the original 60–40 portfolio of stocks and bonds from 0.376 to 0.399–0.416 on average, depending on the portfolio construction methodology employed. During the 6-year period between 2009 and 2014, the blended portfolios have approximately the same average Sharpe ratios and slightly better Calmar ratios than the benchmark portfolio with the minimum risk approaches delivering the best results. The 60–40 portfolio of stocks and bonds has been used extensively in the literature as a benchmark portfolio, the framework is flexible and can incorporate any investor-specific portfolio as a benchmark
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