Performances of Hedge Funds and Standard Assets: A Systematic Investigation

Abstract

In the last decade, the performances of hedge funds were surprisingly satisfactory and recurrent. However, the bankruptcy of LTCM reminded investors of the risks associated with this asset class. The purpose of this study is to analyse systematically the relationship between the performances of hedge funds' strategies and those of standard asset classes via facto r models. As in the existing literature, we open the scope of the factors drawn upon to non-conventional measures such as performance spread or payoff of options on a standard asset class. Furthermore, we add other non-conventional measurements that aim to quantify, inter alia, the intensity of trends, the opportunities generated by range trading or arbitrage operations between various assets or the role of the heterogeneity of individual performances in the stock markets. We highlight the strategies that present a simple exposure to standard assets, those for which this exposure is combined with more complex exposures (notably non-linear/optional ones) and those, lastly, for which it is very difficult to reproduce performances. We notably present a synthetic transition matrix that allows us to link a relatively standard financial scenario and an allocation within major hedge funds' strategies (while giving a degree of confidence about the various strategies). Moreover, we illustrate the importance of extreme risk in hedge funds' strategies. In particular, we will show that once conditioned on usual or normal risk, several strategies present a substantial risk of extreme loss relative to standard asset classes. We analyse the impact of these results for the management of hedge funds in a prospect of asset allocation. We show as well that allocations based on standard measurements of risk (of the variance type) lead to non-optimal portfolios given the risk of extreme loss and suggest other measurements of risk that could be substituted. We then show the attractiveness in terms of return-to-risk ratio of inserting hedge funds into a standard asset portfolio, notably when a high enough individual degree of risk diversification by hedge funds has been achieved by blending strategies (funds of funds).