The diversification benefits of hedge funds and funds of hedge funds
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Maher Kooli is a professor of finance at the School of Business and Management, University of Quebec in Montreal (UQAM). He holds a PhD in finance from Laval University (Quebec) and was a postdoctoral researcher in finance at the Center of Interuniversity Research and Analysis on Organisations. He also worked as a research advisor for la Caisse de Depot et Placement de Quebec (CDP Capital). His current research interests include alternative investments, initial public offerings and mergers and acquisitions.
Practical applications The hedge funds (HF) and the funds of HF universe is evolving rapidly. To explain the growing attraction of these alternative investments, investors often rely on the existence of free lunch. The paper examines the diversification benefits of HF and funds of HF. We rely on mean–variance spanning tests to analyse this issue. It is found that including HF or fund of HF portfolios to a set of benchmark portfolios (US stocks only) provides an extra return for a unit increase in standard deviation. However, this conclusion is less evident when we consider an internationally diversified portfolio as a benchmark. Our message to portfolio managers is that the value added by HF is uncertain and depends upon the opportunity set that is considered. Abstract We examine whether investors can improve their investment opportunity set through the addition of a hedge fund (HF) or fund of HF portfolio to different sets of benchmark portfolios. Using data from 1994 to 2004, we find that HF, as an asset class, improve the mean–variance frontier of sets of benchmark portfolios sorted by firm size and book-to-market ratio. However, we find that the improvement comes mainly from a leftward shift of the global minimum-variance portfolio rather than the tangency portfolio. Furthermore, investors who already hold a diversified portfolio do not improve their investment opportunity set by adding HF portfolios. On the other hand, we find that investing in
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funds of HF, as an asset class, does bring diversification benefits for mean–variance investors, even when we enlarge our investment opportunity set by including fixed income, international assets and commodities. Derivatives Use, Trading & Regulation (2007) 12, 290–300. doi:10.1057/palgrave.dutr.1850053 Keywords: hedge funds; funds of funds; meanvariance spanning test
INTRODUCTION Hedge fund (HF) investment has increased dramatically in the last decade. For instance, Van
Derivatives Use, Trading & Regulation Volume 12 Number 4 2007 www.palgrave-journals.com/dutr
Derivatives Use, Trading & Regulation, Vol. 12 No. 4, 2007, pp. 290–300 r 2007 Palgrave Macmillan Ltd 1357-0927 $30.00
Hedge Fund Advisors International, Inc. reports a total of 8,100 global HF managing close $1.2 trillion in capital at the end of year 2005. To explain the growing attraction of these funds, investors often rely on the existence of free lunch. Indeed, HF table higher average returns than standard market indexes and higher Sharpe ratio. More important, they tend to have lower correla
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