Hedge Fund Portfolio Strategy Based On Performance Persistence And Portfolio Theory

Jingzhong Zhang

Columbia University, Department of Industrial Engineering and Operations Research (IEOR), Students

October 28, 2015

Abstract:

This paper aims to analyze and develop systematic methods to construct funds of funds (FOF) products investing in Chinese hedge funds, with low risk, high return and high Sharpe Ratio, or other ideal characteristics required by investors. Using performance data of more than 600 hedge funds, we tested the persistence of fund performances and constructed momentum strategies based on the positive findings. Starting from that, we also applied standard portfolio theory to design portfolios with optimized risk and return features. Tradable FOF products with low risk, high return and high Sharpe Ratio were described in detail, with outstanding performances confirmed by systematic backtest and robust tests. We also applied Black-Litterman model to flexibly design portfolios so that they have desired risk-return features. Collectively, our results offer a sound investing product based on Chinese hedge fund performance, and are valuable both as an independent product and as a major component in a more comprehensive portfolio.

Hedge Fund Portfolio Strategy Based On Performance Persistence And Portfolio Theory – Introduction

1.1 Research Background

Hedge fund as an alternative investment vehicle has long been a fascinating topic for both the academia and the investing industry. Typically, hedge funds serve wealthy, private clients and manage money under little supervision. The industry has experienced fast growth in the recent twenty years. Between 2009 and 2014, the total inflow to 22800 US hedge funds exceeded $6 trillion based on hedge fund record file Form D with the SEC (Jorion & Schwarz 2015). On the other hand, the hedge fund industry in China is still in its growth stage, compared to the satuated market condition in US. Nevertheless, more than three thousand hedge funds established in 2014. and the industry total AUM was around RMB 2 trillion (Hedge Fund Rankings 2015). Both globally and in China, hedge fund has become a significant market power that investor do not want to ignore.

Traditionally, hedge funds are reputed for sustainable positive returns that are uncorrelated with market trends. Hedge funds usually claim to diversity their risks through hedging positions among different asset classes or neutralization of exposure to common risk factors. Although there are controversial issues related with actual performances of hedge funds, most studies concluded that the top hedge funds enjoy significant excess returns (Brown et al. 1999; Edwards & Caglayan 2001; Capocci et al. 2005; Capocci & Hubner 2004). Some papers confirmed that hedge funds returns were quite independent with stock market return (Brown et a1. 1999). As for Chinese hedge funds, our own analysis showed that most of them displayed significant excess returns and their correlations with the market were very low (between -0.03 and 0.05, data upon request). These features would be really attractive to investors who had lost considerably during the stock market drawdown starting from June 2015. As a growing industry and an alternative investment option, Chinese hedge funds are becoming more and more popular. Their outstanding performances attract investors’ attention, which was substantiated by the accelerating rate in 2014 at which new hedge fund products were issued (Hedge Fund Rankings 2015). It is interesting to explore trading strategies investing in hedge funds in order to guide investors on how to evaluate and allocate capital into different hedge fund products.

Nevertheless, selecting and investing in a single hedge fund or a few of them is risky (Liang 2004). Their collectively significant excess return does not necessarily apply to each single fund. The annual return distribution in some fund classes could typically range from negative 30% to positive 300%. Moreover, it is difficult for investors to collect comprehensive information on their interested fund products, as hedge funds have minimum disclosure requirements and tend to conceal their investment details which they consider material and confidential. Fortunately. investors can cheaply invest in a diversified portfolio of hedge funds through investment in a PCP product that focuses on hedge funds. However. the saving of information cost and reduction of risk may have a price. In fact, FOF underperform individual hedge funds when fee-adjusted return is compared (Brown et al. 2004′. Liang 2004). This suggests that the additional return from FOF’s picking expected top performing hedge funds, if any, cannot justify the fees they charge. Consequently, a PCP strategy that optimizes hedge fund portfolio so that it has higher return and lower risk than the average hedge fund would be very popular among investors.

hedge fund portfolio

hedge fund portfolio

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