Hedging Equity Market Risk in Hedge FundInvesting: A New Approach

Abstract

Hartmann and Kaiser argue that investors in funds of hedge funds underestimate the traditional equity market beta of these perceived absolute return investment vehicles. Hence, during times of financial crisis when the correlations of most asset categories with each other increase dramatically, the traditional equity market beta can have an adverse effect on the performance of funds of funds. Because investors in such environments are rarely able to redeem their fund-of-funds holdings due to low liquidity (e.g.,notice and redemption periods or lock-ups) or extraordinary circumstances (e.g., maximum redemptions, gates, and side pockets), the authors posit that the only way to decrease unwanted exposure is through overlay strategies. The academic literature so far has focused on the multifactor approach to estimate equity exposure in hedge fund portfolios. The authors compare different hedging approaches: a pure value-at-risk (VaR)-based approach, a technical market risk signal approach, and a combination of both over the May 2004–September 2009 period using weekly data from an investable hedge fund index. Their results suggest that using a risk overlay system for funds of hedge funds significantly decreases the downside risk of hedge fund investing during economic crises. <b>TOPICS:</b>Equity portfolio management, VAR and use of alternative risk measures of trading risk, private equity