On the Use of Data Envelopment Analysis as Performance Appraisal Tool for Fund of Hedge Funds with Skewness

Abstract

This paper compares the performance of hedge funds, managed futures funds and funds of hedge funds (FOFs). To date there is a belief that the hedge fund industry is inefficient as information on hedge-fund managers is not available for all market participants at the same time and at the same price. Consequently a fund of funds manager who can access this information more easily has a competitive advantage. They can add value primarily through hedge fund manager selection and construct portfolios better aimed at attaining diversification benefits for investors. Our purpose is to test this belief. However, comparing funds is made harder by the presence of skewness in the distribution of fund returns, which biases any performance measure based only on mean and variance. We showed how skewness can be tackled and alternative measures formulated and used in Data Envelopment Analysis (DEA) to help investigate evidence of 'efficiency' in fund of funds’ performance. We compare the performance of funds of hedge funds with other alternative investments, specifically hedge funds and managed futures funds. These incorporate diversification to a lesser extent than funds of hedge funds. We wish to see whether these funds perform differently to one another. We find mixed evidences on the funds’ performances. Single-Strategy Funds of Hedge Funds shows the greatest loss of efficiency when compared with Managed Futures and Hedge Funds. However, Multi-Strategy Funds of Hedge Fund maintain its same level of efficiency when undergoing similar comparison.