Hedge fund portfolio selection with fund characteristics

Juha Joenväärä,Hannu Kahra,Mikko Kauppila

doi:10.1016/j.jbankfin.2021.106232

Juha Joenväärä, Hannu Kahra + Show 1 more

Open Access

https://doi.org/10.1016/j.jbankfin.2021.106232

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Abstract

This paper examines hedge fund portfolio selection approaches in isolation and in the context of an investor’s overall portfolio. Characteristics-based portfolios that minimize risk delivers superior out-of-sample performance. For instance, a minimum variance portfolio tilting toward small funds with high alpha and strategy distinctiveness index and low systematic risk delivers an annualized Sharpe ratio of 2.03 with a maximum drawdown of 5.20%. Investors realize diversification benefits by shifting a portion of their wealth from 60 to 40 equity-bond portfolio to characteristics-based hedge fund portfolio. Investors recognize the attractiveness of characteristics-based portfolios, but do not target flows enough to erode their superior performance.

Highlights

Hedge funds that manage currently around $5 trillion in assets are an important part of the overall portfolios of institutional investors such as pension funds and endowment funds
Our analysis suggests that especially assets under management (AUM), α and high-water mark (HWM) may be useful for maximizing returns while strategy distinctiveness index (SDI), systematic risk (SR) and R2 could be helpful in achieving a lower risk
Our results imply that investors can achieve higher riskadjusted returns by tilting their hedge fund portfolios toward small funds with high alpha, while risk can be minimized by investing in high strategy distinctiveness funds and low systematic risk funds

Summary

Introduction

Hedge funds that manage currently around $5 trillion in assets are an important part of the overall portfolios of institutional investors such as pension funds and endowment funds. The recent National Association of College and University Business Officers (NACUBO) survey found that university endowment funds typically allocate around 20% of their wealth to hedge funds. Some institutional investors such as California Public Employees’ Retirement System (CalPERS) have been disappointed by the value added by hedge funds. Using a large consolidated hedge fund database, we provide a systematic study that examines the potential value generated by optimal hedge fund portfolios both in isolation and in the context of an investor’s overall portfolio. Our approach relies on recent developments in portfolio choice techniques which model the portfolio’s weights in each asset as a function of the asset’s characteristics..

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