“Overlay hedging” in funds of funds improves alpha: Edhec
Oct 30th, 2008 | Filed under: Portable Alpha & Alpha/Beta Separation, Today's PostOkay. So the truth is out, hedge funds have long equity exposure. Our back-of-the-envelope analysis of the HFRI Index last week showed that all strategies - particularly “Equity Hedge” had a positive correlation with equity markets.
So what can an investor seeking truly uncorrelated returns do about this? After all, it’s quite possible that a hedge fund could produce alpha, but deliver it to investors with a side helping of over-priced beta. Short bias managers, for example, are often said to produce a positive alpha even though they lose their shorts year after year. It’s cases like this that make the term “absolute returns” a misnomer (see related post).
A new paper by the Edhec Risk and Asset Management Research Centre illustrates the ways that a fund of hedge funds can mitigate itself from these not-so-hidden factor exposures.
To begin with there’s that pesky equity exposure. The following graph from the report shows the contribution of the MSCI World (blue line) to the volatility of the HFRI Fund of Funds Index:
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We’ve been approached by a number of groups looking to hedge their FoF portfolios. The problem is that the hedge exposures are far larger than most FoF are comfortable with taking. It’s like giving a 50% notional allocation to a single manager.
For FoF, I think hedging can be used for incremental performance gains (100 to 300bps.) but complete hedging is more of a hybrid product.
For many years, this hedging out standard risks has been used by hedge funds and funds of funds as well as sophisticated investors to create uncorrelated returns. Glad to see that news about this technique has now also reached France. An alternative approach would be to simply eliminate the funds that cause the unwanted correlation, such as equity long/short. Instead of first buying a bit of everything and then implement clumsy corrections, one might as well just buy what is needed. Isn’t that a lot easier?
Nice comment, Harry! For once I agree with you at least partly
The idea about hedging out beta (or alternative beta) is by no means new. Some have attached the name “portable alpha” to it. I have mentioned this idea in my 2004 book (p.150), but I am by no means the originator of that idea, either. I agree to just get rid of pure beta (or alternative beta) players is a good - and not necessarily a very innovative - idea. However, some or most HF managers are a mix of the two. So we will unformtunately not just fix the problem by pouring out the baby with the bath.
Hi Prof. Kat
Its getting a little difficult to find funds that are sufficiently uncorrelated hence the need to ‘re-hedge’. We are doing something similar just using ETF’s which, although they do require the equivalent of a 50% notional allocation to a single L/S Overlay portfolio, overcome some of the weaknesses of a futures based approach. See http://content.infiniti-capital.com/docs/Infiniti%20Pure%20Alpha%20Fund%20(%20Sep%202008%20).pdf
for further details ( Back-tested out-of-sample results. )
Interesting views on the state of research in France by Dr Harry M. Kat.
Unfortunately for the accuracy of his remarks, not only are the authors of the paper in question not French but they are also, in addition to their role as research associate with EDHEC-Risk, operating in an internationally-renowned firm based in the US.
So all we can say at this stage is that the hedging techniques presented in the aforementioned paper are indeed popular in the US. When it comes to the issue of dissemination of the concept in France, we’ll leave Harry the responsibility for his comments, as we have not seen so far any appropriately documented study on the question …
Hi JR,
I knew that French comment would get your juices flowing! Apologies for assuming that research was done by yourselves. Didn’t realize you hire external people to do your research and then simply slap the Edhec label on. Maybe you can now reinstate my password to the Edhec website, which mysteriously got blocked shortly after I posted my earlier comment?