Fund of hedge funds portfolio selection: A multiple-objective approach

Journal of Derivatives and Hedge Funds

Volumn 15, Issue 2, 2009, Pages 91-115

  Davies, Ryan J ^a   Kat, Harry M ^b   Lu, Sa ^c  

^a BABSON COLLEGE   (United States)

^b CITY UNIVERSITY   (United Kingdom)

^c Associate at UBS   (United Kingdom)

Author keywords

Asset allocation; Diversification; Hedge funds; Kurtosis; Optimisation; Skewness

Indexed keywords

EID: 68349128465     PISSN: 17539641     EISSN: 1753965X     Source Type: Journal    
DOI: 10.1057/jdhf.2009.1     Document Type: Article

References (37)

1. MeesPierson's Leveraged Capital Holdings, one of the first multi-manager FoHF, was introduced in 1969.
2. Amin, G.S. and Kat, H.M. (2003) Stocks, bonds and hedge funds: Not a free lunch! Journal of Portfolio Management 30(2): 113-120.
3. Anson, M.J.P. (2002) Symmetric performance measures and asymmetric trading strategies. Journal of Alternative Investments 5(1): 81-85.
4. Of course, this implicitly assumes that investors' utility functions are of higher order than quadratic. For details, see Jean, W.H. (1971) The extension of portfolio analysis to three or more parameters. Journal of Financial and Quantitative Analysis 6: 505-515; and Scott, R.C. and Horvath, P.A. (1980) On the direction of preference for moments of higher order than the variance. Journal of Finance 35(4), 915-919.
5. Tayi, G.K. and Leonard, P.A. (1988) Bank balance-sheet management: An alternative multi-objective model. Journal of Operational Research Society 39(4): 401-410.
6. Lai, T.-Y. (1991) Portfolio selection with skewness: A multiple-objective approach. Review of Quantitative Finance and Accounting 1: 293-305.
7. Chunhachinda, P., Dandapani, K., Hamid, S. and Prakash, A.J. (1997) Portfolio selection and skewness: Evidence from international stock markets. Journal of Banking and Finance 21(2): 143-167.
8. Sun, Q. and Yan, Y. (2003) Skewness persistence with optimal portfolio selection. Journal of Banking and Finance 27(6): 1111-1121.
9. Prakash, A.J., Chang, C.-H. and Pactwa, T.E. (2003) Selecting a portfolio with skewness: Recent evidence from US, European, and Latin American equity markets. Journal of Banking and Finance 27(7): 1375-1390.
10. Examples in the context of hedge funds include Hagelin and Pramborg (Hagelin, N. and Pramborg, B. (2004) Evaluating gains from diversifying into hedge funds using dynamic investment strategies. In: B. Schachter (ed.) Intelligent Hedge Fund Investing. London: Risk Waters Group, pp. 423-445.) who develop a discrete-time dynamic investment model based on an investor with a power utility function, and Barés et al (Barés, P.-A., Gibson, R. and Gyger, S. (2002) Hedge Fund Allocation with Survival Uncertainty and Investment Constraints. Working paper, Swiss Federal Institute of Technology Lausanne EPEL.) who examine the impact of hedge fund survival uncertainty on optimal allocations in an expected utility framework. In a more general asset return context, Harvey et al (Harvey, C.R., Liechty, J.C., Liechty, M.W. and Müller, P. (2004) Portfolio Selection with Higher Moments. Working paper, Duke University.) consider utility- based portfolio optimisation using a new Bayesian decision theoretic framework, which incorporates higher moments and estimation error.
11. Markowitz, H. (1959) Portfolio Selection: Efficient Diversification of Investments. New York: Wiley.
12. Sharpe, W.F. (1970) Portfolio Theory and Capital Markets. New York: McGraw-Hill.
13. Common choices are logarithmic, power and negative exponential utility functions. These functions satisfy the desirable properties: (a) non-satiety with respect to wealth, (b) risk aversion and (c) risk assets are not inferior goods. For more details, see Grauer, R.R. (2004) Are the Effects of Estimation Risk on Asset Allocation Problems Overstated? Working paper, Simon Fraser University.
14. It is worth noting, however, that some of these utility-based approaches do not guarantee the existence of an optimal solution.
15. Cremers, J.-H., Kritzman, M. and Page, S. (2005) Optimal hedge fund allocations: Do higher moments matter? Journal of Portfolio Management 31(3): 70-81.
16. Brulhart, T. and Klein, P. (2005) Are extreme hedge fund returns problematic? Alternative Investment Management Association International Journal 69: 4-6.
17. Anson, M., Ho, H. and Silberstein, K. (2007) Building a hedge fund portfolio with kurtosis and skewness. Journal of Alternative Investments 10(1): 25-34.
18. Favre, L. and Galeano, J.-A. (2002) Mean-modified value at risk optimisation with hedge funds. Journal of Alternative Investments 6(2): 21-25.
19. Lamm Jr., R.M. (2003) Asymmetric returns and optimal hedge fund portfolios. Journal of Alternative Investments 6(2): 9-21.
20. Terhaar, K., Staub, R. and Singer, B. (2003) Appropriate policy allocation for alternative investments. Journal of Portfolio Management 29(3): 101-111.
21. Alexander, C. and Dimitriu, A. (2004) The Art of Investing in Hedge Funds: Fund Selection and Optimal Allocations. Working paper, University of Reading.
22. Cvitanić, J., Lazrak, A., Martellini, L. and Zapatero, F. (2003) Optimal allocation to hedge funds: An empirical analysis. Quantitative Finance 3: 1-12.
23. Amenc, N. and Martellini, L. (2002) Portfolio optimisation and hedge fund style allocation decisions. Journal of Alternative Investments 5(2): 7-20.
24. Popova, I., Morton, D.P., Popova, E. and Yau, J. (2006) Optimal Hedge Fund Allocation with Asymmetric Preferences and Distributions. Working paper, University of Texas at Austin.
25. Amin, G.S. and Kat, H.M. (2003) Welcome to the dark side: Hedge fund attrition and survivorship bias over the period 1994-2001. Journal of Alternative Investments 6(2): 57-73.
26. Brooks, C. and Kat, H.M. (2002) The statistical properties of hedge fund index returns and their implications for investors. Journal of Alternative Investments 5(2): 45-62.
27. Morton, D.P., Popova, E. and Popova, I. (2006) Efficient fund of hedge funds construction under downside risk measures. Journal of Banking and Finance 30(2): 503-518.
28. Amin, G.S. and Kat, H.M. (2002) Portfolios of hedge funds. In: B. Bruce (ed.) Hedge Fund Strategies: A Global Outlook. New York: Institutional Investor, pp. 81-88.
29. Davies, R.J., Kat, H.M. and Lu, S. (2006) Single strategy funds of hedge funds: How many funds? In: G. Gregoriou (ed.) Fund of Hedge Funds: Performance, Assessment, Diversification and Statistical Properties. Amsterdam: Elsevier, pp. 203-210.
30. The optimal number of funds (within a strategy group) is an interesting area which will be dealt with in a subsequent paper. In part, the number of funds reflects a trade-off between possible diversification benefits and the cost of finding and monitoring high-quality funds.
31. Davies, R.J., Kat, H.M. and Lu, S. (2003) Higher Moment Portfolio Analysis with Hedge Funds, Stocks, and Bonds. Working paper, Babson College.
32. Note that this also implies a strong negative co-skewness between hedge funds and the stock market.
33. With more and more convertible arbitrage funds competing for the same trades, some funds may decide to no longer hedge their credit risk exposure to compensate for the loss of margin. Those funds can be expected to exhibit a more aggressive risk profile, especially lower co-skewness with other funds and equity.
34. Black, F. and Litterman, R. (1990) Asset Allocation: Combining Investor Views with Market Equilibrium. Discussion paper, Goldman Sachs.
35. See also: Black, F. and Litterman, R. (1992) Global portfolio optimization. Financial Analysts Journal 48(5): 28-43.
36. In practice, these constraints could reflect the real or perceived need for fund managers, particularly new ones, to match closely the risk profile of the fund's peer group. They could also reflect constraints explicitly imposed by the fund's investors.
37. Amin, G.S. and Kat, H.M. (2003) Hedge fund performance 1990-2000: Do the money machines really add value? Journal of Financial and Quantitative Analysis 38(2): 251-274