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The Art of Investing in Hedge Funds: Fund Selection and Optimal Allocations

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Author Info

  • Carol Alexander

    ()
    (ICMA Centre, University of Reading)

  • Anca Dimitriu

    ()
    (ICMA Centre, University of Reading)

Abstract

With institutional investors increasingly involved in alternative investments, portfolio optimisation within a large universe of hedge funds has become a key area for research. This paper develops a portfolio construction model that is specifically designed for funds of hedge funds, incorporating specific controls for operational limitations, data biases and incompleteness. Absolute performance is targeted by selecting funds according to their relative abnormal return, alpha. Whilst different factor models provide quite different estimates of a hedge fund’s alpha, we find that ranking funds according to their alpha is an efficient selection process. In an extensive out-of-sample historical analysis, funds of funds that are selected in this way and then allocated using constrained minimum variance optimisation are shown to perform much better than the equally weighted portfolio of all funds, or minimum variance portfolios of randomly selected funds. This is true even when hedge funds are selected according to their alphas produced by the simplest factor model. Of the four factor models considered in this analysis the best out-of-sample performance is obtained using the statistical factor model.

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Bibliographic Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2004-01.

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Length: 38 pages
Date of creation: Jan 2004
Date of revision:
Handle: RePEc:rdg:icmadp:icma-dp2004-01

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Web page: http://www.henley.reading.ac.uk/
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Related research

Keywords: Hedge fund; risk adjusted performance; mean-variance; constrained optimisation;

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Cited by:
  1. Giamouridis, Daniel & Vrontos, Ioannis D., 2007. "Hedge fund portfolio construction: A comparison of static and dynamic approaches," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 199-217, January.
  2. Harris, Richard D.F. & Mazibas, Murat, 2010. "Dynamic hedge fund portfolio construction," International Review of Financial Analysis, Elsevier, vol. 19(5), pages 351-357, December.
  3. Jawadi, Fredj & Khanniche, Sabrina, 2012. "Modeling hedge fund exposure to risk factors," Economic Modelling, Elsevier, vol. 29(4), pages 1003-1018.
  4. Vrontos, Spyridon D. & Vrontos, Ioannis D. & Giamouridis, Daniel, 2008. "Hedge fund pricing and model uncertainty," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 741-753, May.

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