Hedge Fund Portfolio Construction
Soerensen, Jan T.
- Submitted in partial fulfillment of the degree Master of Arts in Law and Diplomacy at the Fletcher School of Law and Diplomacy. Abstract: Investing in hedge funds requires a diversified and well-constructed portfolio of different hedge fund strategies to ensure that risks at both the individual fund manager level and the systemic level are minimized. The different hedge fund strategies are exposed ... read moreto different systemic risks, and returns will therefore change with changes in the market environment. These different risk/return profiles provide almost endless possibilities for creating value through active portfolio allocation, where strategies interplay to generate consistent absolute returns. A prerequisite for a successful allocation is a thorough understanding of the different risk/return drivers in each strategy. Risk in hedge funds comes primarily through exposure to the different underlying security instruments which the funds use to generate returns. A number of hedge fund strategies invest in more than one asset class, thereby diversifying the return generation, but not necessarily reducing the total risk exposure. An explanation for the risk in some of the hedge fund strategies can be found through regression analysis against other market indicators, while some strategies can only partly be explained by regression analysis. This lack of clearly defined market risk does not indicate that the strategy is risk-free, but merely that the associated risks are non-quantifiable, due to the use of non-linear return methods such as derivatives and leverage. The optimal portfolio allocation will always be a trade-off among the risks an investor is willing to incur for an anticipated return level. Risks can be measured both as standard deviation and as Value-at-Risk, but a hedge fund portfolio should be constructed with the mean-variance optimization model, as none of the hedge fund strategies can be rejected for normality if the return distribution is considered according to time relevance. The separation of the hedge fund portfolio into a core and a tactical part would be useful for sophisticated hedge fund investors who have the ability to actively follow market environments, and monitor the risk/return parameters continuously. For the less sophisticated investor, the hedge fund portfolio should be kept at a core level with a long-term investment objective. Due to opaque investment methods, hedge fund investing requires specialized skills, such as an understanding of complex security instruments, extensive industry knowledge, and analytical ability. An institution or high net worth individual may benefit from an intermediary partner e.g. a fund of hedge funds who possesses the necessary qualifications and skills to filter through the many thousands of hedge funds and understands how the different hedge fund strategies can be optimally combined to generate consistent absolute returns.read less