Funds of hedge funds (FoHF) are an alternative vehicle of investing directly in single-manager hedge funds, as they comprise a pool of hedge funds that provides investors with diversification. The question that arises is if the returns yielded by the FoHF are driven by idiosyncratic factors justifying existing management fees or they are just result of market movements. According to BarclayHedge, the assets under management in the hedge fund industry reached almost $3.2 trillion in the second quarter of 2015, out of which $467.7 billion are attributed to FoHF. It is obvious that FoHF constitute a large and growing market that requires a lot of attention from the investors.
FoHF theoretically have a lot of advantages compared to the single manager hedge funds that render them into a very popular investment choice. First of all, the investment in a well-diversified basket of hedge funds implies reduction of fund-specific or non-systematic risk. Secondly, FoHF managers should be expected to have the skills in order to invest in the best single-manager hedge funds and ensure a better market timing among the various hedge fund strategies. Those advantages could mean that FoHF managers are able to channel alpha above the one of the underlying hedge funds.
From a total universe of 7,533 hedge funds examined, 1,475 of them are FoHF and the funds report monthly in U.S. dollar currency. The assessment of their performance is based on a two-dimensional basis, the first conducted through a 5-factor regression model and the second is carried out by the construction of 1475 artificial FoHF to investigate if the returns yielded are subject to skill or to luck. The HFR database distinguishes four main strategies: Equity Hedge, Event-Driven, Macro and Relative Value, so the model aims to identify idiosyncratic-based returns that are not driven by the performance of the aforementioned strategies. The population regression model is quoted below:
FoHF= α + β1* HFRIEQH +β2* HFRIEVD +β3* HFRIMAC + β4* HFRIRVR + ε
- α is the constant factor of the function
- HFRIEQH is the HFRI Equity Hedge Index
- HFRIEVD is the HFRI Event Drive Index
- HFRIMAC is the HFRI Macro Index
- HFRIRVR is the HFRI Relative Value Index
- And βi are the coefficients of the independent variables
The second stage of this perspective as explained above compromises the construction of artificial FoHF, each of them including 15 random single-manager hedge funds. Then a comparison between 50 random and real funds is performed in order to assess the luck existence in the funds’ selection.
Firstly, in order to test the hypothesis of equal returns an unequal variance test is conducted between real and artificial portfolios. The inequality between the differences in variances is easily noticed with the Kernel density distribution graphs quoted below.
H0: μart = μreal
H1: μart <μreal
The findings of this perspective evidence a statistical indifference between real and artificial performance meaning that naïve investors without expertise can achieve the same returns with a sophisticated manager. Automatically, the fees charged for management are under question, so the investors should be extremely diligent in the manager selection.
This perspective does not suggest random investing, but diligent selection in managers. Furthermore, the findings concern a period of time and do not imply their persistence over time. For Stone Mountain Capital LTD the selection of single and FoHF managers is of high importance and it is always done with respect to adding value to potential investors. This perspective is neither an offer to sell nor a solicitation of an offer to buy an interest in any investment or advisory service by Stone Mountain Capital LTD.
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