The Diversification Properties of Hedge Fund Investments

Abstract

The assets invested in hedge funds globally have increased dramatically over recent years. While at the beginning of the 90s less than 50 billion US dollars were invested in hedge funds, it is estimated that at the end of 2003 the total amount committed to hedge funds stood at close to 700 billion US dollars. Most of the growth in assets has been achieved over the recent bear market when hedge funds were propagated as an alternative to equity investments. Hedge funds are bought for two reasons: Firstly, stable returns and secondly, low systematic risk, in particular a low correlation with the equity market. Recent research has cast doubt on some of those beneficial diversification properties of hedge fund investments. Fung and Hsieh (2002) find a high degree of correlation between hedge fund indexes and standard asset classes like U.S. and non U.S. equities or high yield U.S. bonds. Amin and Kat (2003) demonstrate that adding hedge funds to a balanced portfolio reduces for a given return level the standard deviation but also reduces skeewness and increases kurtosis. Liew (2003) suggests that the expected diversification benefits of hedge funds are illusory and disappear under extreme market conditions. In down markets hedge fund aggregate exposure to the market tends to increase rapidly. Liew is able to show that the beta between the CSFB/Tremont index and the S&P500 increases in periods of market dislocation with betas near unity in the most extreme cases. For other studies documenting the changes of hedge fund correlation in bull and bear markets see Edwards (2001) and Schneeweis (1999). The current study extends the existing research on the diversification properties of hedge fund investments in two ways: Firstly, we employ fund of hedge funds (FoHF) to measure the characteristics of investors' hedge fund investments. The advantages of using FoHF instead of hedge fund indexes or pro forma returns of a portfolio of individual hedge funds extracted from a data base are on the one hand a more realistic depiction of investors' investment opportunities and on the other hand a better data quality. When analysing the returns of FoHF we are studying real world investments instead of non investable indexes or artificially constructed portfolios. An additional benefit of using FoHF-data is that the track records of FoHF avoid many of the measurement biases that are embedded in the databases on individual funds, see Fung and Hsieh (2000, 2002). Secondly, we analyse explicitly the impact of different strategies pursued by the FoHF-managers. This is in contrast to previous studies which only look at the aggregate universe of hedge fund investments. The universe of hedge funds is very heterogeneous. There are significant differences between the skills as well as the strategies pursued by the individual hedge fund managers. The FoHF take advantage of this heterogeneity and aim for specific return profiles. By analysing the risk and return characteristics of the different FoHF-categories we are able to assess the opportunities arising to investors' through the specialisation in the hedge fund industry. The study is organised as follows: In section 1 we survey the FoHF-industry and discuss the hedge fund data base. Section 2 analyses the trade off an investor faces when diversifying between hedge fund investments: lower idiosyncratic risk versus higher systematic market risk. As a proxy for market risk we use the correlation with developed and emerging equity markets, government bonds, and global credit spreads. Section 3 extends the analysis to different strategies, pursued by the FoHF-managers. We examine the benefits arising to investors by being able to choose between different FoHF-strategies. In addition, the results of this section give answer to the question to what extent the changes in the idiosyncratic and systematic risk levels, resulting from diversification among different FoHF-managers are due to the combination of different styles or different manager skills. Section 4 looks at the development of idiosyncratic and systematic risk over time. This does not only allow us to examine the robustness of our results but also gives us the opportunity to analyse the diversification properties of hedge fund investments in different market environments. Section 5 concludes this study and summarises the implications for diversification properties of hedge fund investments in different market environments. Section 5 concludes this study and summarises the implications for investors.