On the Performance of Alternative Investments: CTAs, Hedge Funds, and Funds-of-Funds

Abstract

In this paper, we study alternative investment vehicles such as hedge funds, funds-of-funds, and commodity trading advisors (CTAs) by investigating their performance, risk, and fund characteristics. Differing from the previous studies that pool these investment vehicles, we consider them as three distinctive investment classes. We study them not only on a stand-alone basis but also on a portfolio basis. We find several interesting results. First, CTAs differ from hedge funds and funds-of-funds in terms of trading strategies, attrition rates and survivorship bias, liquidities, and correlation structures in different market environments. However, funds-of-funds are similar to hedge funds in these dimensions. Second, during the period of 1994 to 2001, hedge funds outperform funds-of-funds, which in turn outperform CTAs on a stand-alone basis. These results can be explained by the double fee structure but not survivorship bias. Third, correlation structures for alternative investment vehicles are different under different market conditions. Hedge funds are highly correlated to each other and are not well hedged in the down markets with liquidity squeeze. The negative correlations with other instruments make CTAs suitable hedging instruments for insuring downside risk. When adding CTAs to the hedge fund portfolio or the fund-of-fund portfolio, investors can benefit significantly from the risk-return trade-off.