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WHI TE PAPER - I SSUE #11

L Y X O R R E S E A R C H
HEDGE FUNDS IN STRATEGIC ASSET ALLOCATION
ZLIA CAZALET
Quantitative Research
Lyxor Asset Management
BAN ZHENG
Quantitative Research
Lyxor Asset Management
M A R C H 2 0 1 4
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Foreword
Total assets under management for the hedge fund industry reached an all-time high
of USD 2.6 trillion in 2013
1
. With lower expectations for traditional assets, many institu-
tional investors, including pension funds and corporate, are lending increasing allocation to
alternative assets to secure both performance and resilience for their portfolios. As a result,
hedge funds are now growing faster than any other type of asset. They are expected to reach
USD 3.3 trillion by 2015 with a compound annual growth rates of around 15%
2
.
This 11th white paper looks at hedge funds from a new perspective, in the context of
Strategic Asset Allocation (SAA). We see the growth of the assets managed the industry as
an implicit consequence of the dierent approach taken with regard to hedge fund invest-
ments.
Numerous studies using pre-2008 data have shown the benets of adding hedge funds
to SAA. Hedge funds were previously considered to be a stand-alone asset which should
account for a small percentage of overall portfolios. Now, in the aftermath of the nancial
crisis, a new paradigm has appeared: hedge funds are becoming mature investment
styles exhibiting signicant and persistent performance divergence both with
each other and when compared to traditional assets.
As such, hedge fund strategies should be disaggregated into sensible sub-categories which
should naturally migrate from a stand-alone asset into the broader equity and bond
asset-mix. In this context, we propose a reassessment of the relationship between hedge
fund strategies and traditional markets to introduce an updated SAA framework with
hedge funds.
To highlight the above points, this paper addresses the following structural questions:
What are the stylized facts of hedge fund performance in the post-2008
environment?
How should we classify hedge funds in order to better reect their true
characteristics?
What is the best way to integrate the new classication process into a SAA
approach?
We hope you will nd this article both interesting and useful in practice.
Jean-Marc Stenger
Chief Investment Ocer for Alternative Investments
1
Hedge Fund Research database, 2013.
2
The New Challenge for Hedge Funds: Operational Excellence, Boston Consulting Group, 2013.
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Executive Summary
Introduction
Alternative investments, including hedge funds, have grown faster than non-alternatives
and have now surpassed their 2007 levels. For this reason, institutional investors expect
to increase allocations to alternative classes, especially hedge funds. It seems that many
investors are still following the traditional approach to examining their SAA with hedge
funds because many academic and empirical studies are based on pre-2008 data.
As the performance of hedge funds is becoming less homogeneous
than in the past, it is of the utmost importance to re-examine the
SAA with hedge funds.
In our investment philosophy, hedge funds can be regarded as (equity or bond) beta
providers or pure alpha generators. Intelligent use of beta provider hedge funds allows more
ecient risk diversication compared to traditional assets. Moreover, it is worthwhile
to introduce some pure alpha generator hedge funds to generate uncorrelated absolute
return. To take advantage of these benets, we propose a new process for classifying
hedge funds into two families: equity/bond substitutes and diversiers. To take into
account economic periodicity, we then propose a regime switching mean-variance model for
determining the hedge fund allocation in strategic asset allocation.
A new vision of hedge funds after the subprime crisis
Hedge funds are more resilient than traditional assets during crisis peri-
ods.
In the post-2008 environment, it is no longer possible to consider hedge
funds as a single asset class.
Many academic studies show that hedge funds are generally more resilient than equities and
bonds in extreme periods, with hedge fund losses being three times lower than the largest
falls suered by equities. In addition, hedge fund returns are very positive in comparison
with the biggest losses made by bonds.
Moreover, several studies report homogeneous attractive hedge fund performance for
almost all hedge fund strategies using data from before the subprime crisis in 2008. This
homogeneity allows investors to consider hedge funds as a single asset class in strategic asset
allocation. Nevertheless, many dierences between strategies appeared during the subprime
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crisis period. For instance, Equity Hedge suered from big losses whereas Macro fared
better. The dierence between hedge fund strategies in terms of performance and volatility
has persisted since 2008.
A new process for classifying heterogeneous hedge funds
We can classify hedge funds in two groups:
Substitutes, which aim to replace equities and bonds in order to improve
portfolios risk/return proles;
Diversiers, which aim to generate absolute performance and diversi-
cation.
When we break down hedge fund returns into beta return and alpha return, we can see
that some hedge funds have more signicant beta return than alpha return and vice-versa.
We can therefore categorize some hedge funds as equity/bond substitutes (more signicant
beta return) or diversiers (more signicant alpha return) according to the breakdown of
hedge fund returns. Substitutes aim to improve the risk/return prole of traditional assets
(equities or bonds) whereas diversiers generate absolute performance and diversication.
This classication process is described in Figure 1 and the classied hedge funds can be
found in Table 1.
Figure 1: A new hedge fund classication process for SAA
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Table 1: Equity/bond substitutes and diversiers
Substitutes
Equity substitutes EH: Quantitative Directional
Bond substitutes
ED: Distressed
Macro
RV: Fixed Income Asset Convertible Arbitrage
RV: Fixed Income Asset Corporate
RV: Multi Strategy
EH: Equity Market Neutral
Diversiers ED: Merger Arbitrage
RV: Fixed Income Asset Backed
ED, EH and RV denote respectively Event-Driven, Equity Hedge and Relative Value.
Smart strategic asset allocation with hedge funds
Figure 2: Investment philosophy of smart strategic asset allocation with hedge funds
1
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Much research using hedge fund data from before 2008 uses a simple Markowitz mean-
variance framework to study the problem of allocating hedge funds in SAA. Nevertheless,
due to the non-normal distribution (asymmetric and/or fat-tailed) of hedge fund returns, a
simple Markowitz mean-variance framework will likely lead to an inecient portfolio com-
position and also underestimate tail risk. One possible solution consists in getting rid of the
non-normal distribution of hedge funds by considering a Markowitz mean-variance frame-
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work with regime switching. In addition to the investment philosophy of smart strategic
asset allocation with hedge funds described in Figure 2, we assume that the xed long-term
economic environment remains within in two xed regimes: an extreme regime (with high
nancial market stress) and a normal regime (with low nancial market stress). We then
determine the allocation strategy in these two regimes.
In this study, we assume that 15% of the portfolio is invested in hedge funds. We
then determine the allocation strategy with equity/bond substitutes and diversiers with
respect to economic regimes by minimizing the standard deviation of the expected annual
return subject to the constraints on the performance objective and parameters. For the
normal market regime, the allocation strategy with respect to the risk appetite parameter
is presented in Figure 3.
In the normal market regime, it is possible to give priority to dierent
families of hedge funds according to the target portfolio volatility.
Low risk appetite: investors with target volatility below 6.5% prefer
equity substitutes.
Medium risk appetite: investors with target volatility between 6.5%
and 7.5% invest in diversiers.
High risk appetite: investors with target volatility above 7.5% prefer
bond substitutes.
Figure 3: Allocation strategy with respect to the risk appetite
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Conclusion
Hedge funds are attractive investment tools, but are more sophisticated than traditional
assets and therefore require more investment expertise. Hedge funds have become noticeably
more mature in recent years, meaning that it is time to reassess hedge fund investments in
SAA. The granularity of hedge funds allows us to evaluate and classify them according to
their sensitivity to common risk factors. Hedge funds can be classied into equity/bond
substitutes and diversiers. Taking into account the non-normal distribution of hedge fund
returns and economic periodicity, a regime switching Markowitz model is applied to examine
portfolio allocation in an extreme market regime and a normal market regime. We show that
investors should choose equity substitutes in an extreme market regime, while in a normal
market regime, it is recommended for investors to use equity substitutes, diversiers and
bond substitutes if they are aiming for low, medium and high volatility respectively.
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Table of Contents
1 Introduction 13
2 Hedge fund overview 15
2.1 Hedge fund databases . . . . . . . . . . . . . . . . . . . . . . . . 15
2.1.1 Biases in database construction . . . . . . . . . . . . . . 15
2.1.2 Private hedge funds databases and indices . . . . . . . . 16
2.2 Stylized facts of hedge funds . . . . . . . . . . . . . . . . . . . . 17
2.2.1 Basic statistics of hedge fund indices . . . . . . . . . . . 18
2.2.2 Survivorship bias . . . . . . . . . . . . . . . . . . . . . . 20
2.2.3 Abnormal distribution and fat tail risk . . . . . . . . . . 21
2.2.4 Performance persistence . . . . . . . . . . . . . . . . . . 22
2.2.5 Auto-correlation . . . . . . . . . . . . . . . . . . . . . . 23
2.2.6 Cross-correlation with traditional assets . . . . . . . . . 24
2.3 Quantitative classication of hedge funds . . . . . . . . . . . . . 26
3 Investment vehicles 28
3.1 Single hedge funds and managed account platforms . . . . . . . 28
3.2 Funds of hedge funds and multi-strategy funds . . . . . . . . . . 29
3.3 Hedge fund indices replicators . . . . . . . . . . . . . . . . . . . 30
4 Benets and risks of hedge funds investments 31
4.1 Benets of hedge funds investments . . . . . . . . . . . . . . . . 31
4.1.1 Signicant risk-adjusted return . . . . . . . . . . . . . . 31
4.1.2 Ecient diversication of risks . . . . . . . . . . . . . . . 32
4.1.3 Resistance to market environments . . . . . . . . . . . . 37
4.2 Risks of hedge fund investments . . . . . . . . . . . . . . . . . . 38
5 Smart strategic asset allocation with hedge funds 41
5.1 Equity/bond substitutes or diversiers . . . . . . . . . . . . . . 43
5.2 How much should we invest in hedge funds? . . . . . . . . . . . 45
6 Conclusion 50
A Comparison of classication in dierent databases 52
B Markowitz mean variance model with regime switching 53
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From Niche to Mainstream: A New Approach
to Utilizing Hedge Funds in Strategic Asset
Allocation
Zelia Cazalet
Quantitative Research
Lyxor Asset Management, Paris
zelia.cazalet@lyxor.com
Ban Zheng
Quantitative Research
Lyxor Asset Management, Paris
ban.zheng@lyxor.com
March 2014
Abstract
Over recent decades, the hedge fund industry has expanded rapidly. Its development
has enabled the creation of a new asset class in its own right. Hedge funds have become
more attractive in recent years, especially for family oces and institutional investors.
The objective of this paper is to provide a comprehensive overview of hedge funds in the
most detailed way possible and propose an innovative approach to placing hedge funds
in strategic asset allocation (SAA). Using the HFR database, we review the stylized
facts, benets and risks of hedge funds. We propose a new method of classifying hedge
funds as equity/bond substitutes and diversiers. We then examine SAA in extreme
and normal regimes using the Markowitz mean-variance model with regime switching.
Keywords: Hedge fund, strategic asset allocation, Markowitz, regime switching.
JEL classication: G11.
1 Introduction
Hedge funds have experienced explosive growth in recent decades and assets under manage-
ment in the global hedge fund industry totalled USD 2.6 trillion in 2013 according to Hedge
Fund Research. Nonetheless, they needed time to emerge from the shadows and to become
a very attractive asset class in recent decades. The key principles of the rst single-hedge
fund were introduced by the statistician Karsten in his book Scientic Forecasting published
in 1931. However, the creation of the rst large hedge fund by Jones did not occur until
1949. His investment process combined long positions in undervalued stocks and short po-
sitions in overvalued ones, adding leverage by nancing long positions from short sales and
introducing performance-linked fees (20% of realized prots). It was not until 1966 that a
newspaper article written by Loomis described this process and introduced the term hedge
fund for the rst time (Lhabitant, 2006).
After that, the alternative industry experienced strong growth during the huge bull
market of the 1950s and 1960s. Caldwell (1995) reports that a 1968 SEC survey found that
140 out of 215 investment partnerships were probably hedge funds. Many of the future
industry leaders started their funds during this period such as Warren Buetts Omaha-
based Buett Partnership, the rst fund of hedge fund Walter J. Schlosss WJS Partners
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and the George Soros Quantum Fund. Nevertheless, hedge funds went through a dicult
period from the end of 1960s to the beginning of 1980s. Their popularity revived again
in 1986 thanks to an article by Rohrer entitled Institutional Investor. He highlighted the
outperformance of Julian Robertons Tiger Fund campared with the S&P 500 over the rst
six years of its existence. Julian Robertons investment was based on macroeconomic analysis
(occasionally without a hedging policy) and on allocation to nancial derivatives such as
futures and options. This strategy is referred to as global macro which had great success in
the late 1980s thanks to the weak US dollar, the rise of equity markets, commodity markets
and interest rates and the fall of bond market.
Then, like most other traditional asset classes, hedge funds were severely hurt by nan-
cial crises such as the crash of October 1987, the Gulf war in 1990, the European currency
crisis in 1992 and 1993 or the Mexico crisis in 1994. However, hedge funds recover bet-
ter and faster than nancial markets as a whole. Thus, during this period, many new
strategies emerged including credit arbitrage, distressed debt, xed income, quantitative,
multi-strategy etc. In addition, many institutional investors such as pension and endow-
ment funds began to allocate a greater portion of their portfolios to hedge funds achieving
very attractive performance (Swensen, 2000).
In 1998, the collapse of Long Term Capital Management (LTCM) which was founded by
Meriwether and run by future Nobel Laureates Scholes and Merton, represents a landmark in
the evolution of the hedge fund industry. It acted as a wake-up call for all markets regarding
the need for greater transparency and better practices. Hedge funds sharply reduced their
leverage, agreed to provide their investors with greater transparency, and improved their risk
management. During the subprime mortgage crisis in 2007 and 2008, despite a double-digit
loss for the Credit Suisse/Tremont hedge fund index, hedge funds outperformed the global
equity market. Meanwhile, the fraud by Mado Investment Securities LLC in 2008 drove
regulators to impose a tighter and more stringent regulatory framework requiring extended
hedge fund registration and reporting. Increased regulation aimed at protecting investors
in recent years is seen as boosting investor condence and adding value to the hedge fund
industry.
Due to their eventful history, hedge funds have become a key investment vehicle in
modern nance. They represent an important nancial instrument in the growing alternative
investment market. Recently, alternative investments have experienced higher growth than
non-alternative investments. Farrell et al. (2008) show that compound annual growth rates
are 14.2% and 1.9% respectively for alternative investments and non-alternative investments
from 2000 to 2007. Erzan et al. (2012) state that alternative investments have grown faster
than non-alternatives over the last six years and have surpassed peak 2007 levels. They
report that assets under management in hedge funds reached USD 2.25 trillion at the end of
2012 and are expected to reach USD 34.9 trillion in 2013. They also show that institutional
investors expect to increase allocations to hedge funds as well as other alternative classes
such as private equity or real estate.
In spite of major growth in investment in hedge funds and academics increasing interest
in this subject, there is still much to be done in this area of research. Unlike the case of
traditional assets, few investors have a detailed overview of hedge funds in terms of their
stylized facts, benets, risks and especially their role in SAA. In this paper, we hope to
provide an overview of these subjects and propose a new hedge fund allocation process in
SAA using a regime switching mean-variance model.
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Our paper is organized as follows. In Section 2, we provide an overview of the hedge
fund industry. We present dierent hedge fund databases and study the stylized facts
and quantitative classication of hedge funds using the HFR database. Then, we examine
dierent hedge fund investment vehicles in Section 3. In Section 4, we present the benets
and risks of investing in hedge funds. Section 5 is dedicated to proposing an innovative
approach to classifying hedge funds as equity/bond substitutes and diversiers. It then
examines the SAA in extreme regime and normal regimes using Markowitzs mean-variance
portfolio selection with regime switching.
2 Hedge fund overview
In what follows, we present the main characteristics of hedge funds. In the rst paragraph,
we introduce dierent databases used by investors and academics and their respective clas-
sication methods. We then present the basic statistics on HFRI indices and their stylized
facts such as fat-tail risk, performance persistence, auto-correlation and cross-correlation
with traditional assets. We conclude this section with a quantitative classication.
2.1 Hedge fund databases
Studying the statistics and stylized facts of hedge funds requires the gathering of good in-
formation about the hedge fund industry. It is necessary as a minimum to have data on the
returns and the qualitative investment styles of hedge funds. Hedge funds do not have a
public organization which ocially collects this type of information. Meanwhile, fund man-
agers voluntarily release monthly return information to the specialised databases to which
practitioners and academics must pay a subscription to gain access rights. The database
providers also oer other services like hedge fund indices which are widely used in the in-
dustry. However, we must be careful because these databases and their respective indices
do not exactly represent the whole hedge fund universe. All these databases and indices can
be built according to dierent methodologies. It is important to highlight existing biases
to be taken into account in statistical analysis before choosing the appropriate database to
study.
2.1.1 Biases in database construction
In this paragraph, we list dierent biases in database construction that we have to keep in
mind before doing any statistical analysis.
First we look at the selection bias. Hedge funds are private investment solutions and
have no obligation to report their performance. They only have to communicate their
performance to their own investors. There is no public organization which ocially collects
this type of data. Hedge funds decide for themselves what to communicate in prospectuses
and voluntarily provide information about their performance if they need more visibility.
Thus, while small funds with good performance are eager to report their performance,
bad funds do not want to report their performance since they do not wish to suer from
competition. Moreover, famous large funds with exceptional performance are not interested
in this visibility. As a result, the selection bias is linked to the data sources and may be
amplied in the proprietary construction of databases. Indeed, some databases follow certain
reporting rules such as minimum assets under management and performance records. The
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lack of representativeness and homogeneity of database construction rules and the selective
reporting rules of some hedge funds lead to partial representation of the whole hedge fund
industry by each database.
Another important bias is the survivorship bias which is often mentioned in many re-
search papers. The survivorship bias results from the tendency to exclude dead funds
from statistical study when their performance is no longer reported. A fund is supposed to
be dead when it is liquidated, closed, merged or simply when it stops reporting. Although
some researchers only focus on live funds which are surviving funds on the date of the study,
it is biased to analyze the behavior of the whole hedge fund world over a long period by
using live funds. Many studies have been carried out on this subject with the database of
mutual funds or hedge funds (Malkiel, 1995, Elton et al., 1996, Brown and Goetzmann, 1997,
Ackermann et al., 1999, Brown et al., 1999, Fung and Hsieh, 2000, Liang, 2000, Agarwal et
al., 2013, Aiken et al., 2013).
Hedge fund databases also face a backll bias. When a hedge fund is added to a database,
its manager can choose whether or not to report its returns over the incubation period
prior to the date of submission. Hence, there is a bias resulting from the fact that funds
with satisfying performance over the incubation period report their returns whereas funds
with disappointing performance prefer to provide returns only after the submission date.
Moreover, for some hedge funds, there is a time lag between the realisation time and the
reporting time. Liang (2000) documents the backll bias by discovering that the same fund
in several databases has not reported its return since the same date. Barry (2003) highlights
dierent backll durations in each database.
Finally, since hedge funds often invest in illiquid assets for which market prices are not
readily available, we may face liquidity bias in hedge fund databases due to the smoothing of
prices in the valuation process (Cici et al., 2011). To account for liquidity bias, Getmansky
et al. (2004) propose an approach to uncover the unobserved (true) returns which are
supposed to be serially uncorrelated contrary to the serially correlated observed returns.
However, Ammann et al. (2011, 2013) investigate liquidity bias but nd it to be very small.
2.1.2 Private hedge funds databases and indices
In this paragraph, we present dierent hedge fund databases. We can nd details of various
databases in Brooks and Kat (2002) and Lhabitant (2006). Here, we only deal with the
databases most frequently used by investors and academics. We then compare their dierent
classication methods and dene the usual hedge fund strategies.
The Hedge Fund Research (HFR) database has reported the performance net of fees of
nearly 7, 000 funds and funds of funds since 1990. It has also built 32 HFRI indices which are
equally weighted indices. These HFRI indices aim to reect the hedge fund industry globally
or by strategies and are widely used by practitioners. The HFRI indices are the most popular
indices which benchmark the total hedge funds industry with almost 2, 200 funds (provided
by Hedge Fund Research, Inc. in August 2013). HFR also proposes HFRX indices which are
daily investable and transparent indices of the hedge fund industry. Recently, they created
HFRU indices which are benchmarks for UCITS hedge funds.
The TASS or Lipper database contains the performance of 7, 500 live funds and funds
of funds plus more than 11, 000 dead funds. The relative indices are the 14 value-weighted
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CSFB/Tremont indices. They result from the joint venture between Credit Suisse First
Boston, a leading investment bank, and Tremont Advisor Inc., a nancial services company
specialised in hedge fund consulting. There are 13 indices which correspond to 13 hedge fund
strategies reported in the TASS database. They also propose the Credit Suisse/Tremont
Hedge Fund Index which is a benchmark of the hedge fund industry.
The Morningstar Center for International Securities and Derivatives Markets (CISDM)
database has reported the performance of more than 5, 000 live hedge funds, funds of funds
and CTAs since 1994. It was formerly Managed Account Reports (MAR) database which
was highly recognized by academics. Eleven indices are constructed in this database: CISDM
Fund of Fund index, eight individual CISDM Hedge Fund Strategy Indices representing the
median performance of relative funds, the CISDM Equal Weighted Hedge Fund Index and
CISDM CTA Equal Weighted Index reecting the average performance of all hedge funds
and CTAs.
The EurekaHedge database was created by ABN Amro and Eurekahedge Fund Advi-
sor. This database refers to about 6, 700 funds and 2, 800 funds of funds. Like other data
providers, they oer a benchmark for the hedge fund industry with the Eureka Hedge Fund
Index which is an equally-weighted index. They also build geographical indices for North
America, Europe, Asia, Latin America and Emerging Markets. More recently, they have
proposed indices for UCITS hedge funds, long-only absolute return funds and funds of funds.
As mentioned above, each data provider is in possession of its own database and its
personalized benchmarks. Qualitative classication methods vary from one database to
another and depends completely on the interpretation of each data provider. In Table 20
in Appendix A, we present strategies and sub-strategies classied in the databases of HFR,
TASS, CISDM and Eurekahedge and try to match their classications for a better overview.
All hedge funds are classied in four main strategies: Equity Hedge, Event-Driven, Macro
and Relative Value. The Equity Hedge strategy corresponds to an investment strategy with
long and short positions in equity or equity derivatives securities. The Event-Driven strategy
takes positions on companies concerned by corporate events. The Macro strategy runs CTAs
or applies macroeconomic analysis to take bets on the major risk factors such as currencies,
interest rates, stock indices and commodities. The Relative Value strategy is characterized
by the fact that the manager simultaneously purchases a security expected to appreciate
and short sells a related security expected to depreciate.
Despite all the biases mentioned above, hedge fund databases provide a remarkable source
of information to understand the behavior of hedge funds. In what follows, we decide to use
the HFR database in our study which is the most frequently referenced by investors and
practitioners (Jagannathan et al., 2010, Cumming et al., 2012, Joenv aar a and Kosowski,
2013, etc.).
2.2 Stylized facts of hedge funds
In this section, we present a comprehensive study of the stylized facts of hedge funds using
the HFR database from January 2000 to June 2013. We provide basic statistics of hedge
fund indices and we illustrate the characteristics on hedge funds such as survivorship bias,
abnormal distribution and fat-tail risk, performance persistence, auto-correlation and cross-
correlation with traditional assets. In what follows, we facilitate notation by using the
abbreviations of the hedge fund indices referenced in Table 2.
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Table 2: Abbreviation of hedge fund strategies
Strategy Abbreviation
HFRI Fund Weighted Composite Index HFRI
Equity Hedge EH
Event-Driven ED
Macro Macro
Relative Value RV
Equity Hedge Equity Market Neutral EH: EMN
Equity Hedge Quant. Directional EH: QD
Equity Hedge Short Bias EH: SB
Equity Hedge Sector Energy Basic Mat EH: S-EB
Equity Hedge Sector Tech Health EH: S-TH
Event Driven Merger Arbitrage ED: MA
Event Driven Private Issue ED: PI
Event Driven Distressed ED: DIS
Macro Syst. Diversied ED: SD
Relative Value Yield Alternative RV: YA
Relative Value Fixed Income Asset Backed RV: FI-AB
Relative Value Fixed Income Asset Convertible Arbitrage RV: FI-CA
Relative Value Fixed Income Asset Corporate RV: FI-C
Relative Value Multi Strategy RV: MS
2.2.1 Basic statistics of hedge fund indices
In this paragraph, we give a global view of hedge fund strategies and sub-strategies from
January 2000 to June 2013. In Figure 4, we can see the evolution of the four main strategies
that we can compare to the HFRI global index. Thus, we notice that the hedge fund
strategies good performance continues until the beginning of the subprime crisis. Hedge
funds are then hurt by the crisis like other traditional assets, but they quickly recover from
2009 until regaining their highest pre-crisis level at the end of the year 2009. Even if we can
highlight this global hedge fund trend, we also observe some signicant dierences between
each main strategy. This is corroborated by statistics in Table 3 which show that the
EH strategy has the highest volatility (9.03%), the most important maximum drawdown
(30.59%) and the lowest Sharpe ratio (0.28) although RV has the lowest volatility (4.41%)
and the highest Sharpe ratio (1.06). Macro (including global macro, CTAs etc.) is the
strategy with the lowest maximum drawdown (7.32%) and low volatility (5.44%). Indeed,
we can see in Figure 4 that Macro is the only one which withstands the subprime crisis. In
addition, ED is the most ecient strategy in our study period with an annual performance
of 7.47%. Heterogeneity between hedge funds is also demonstrated by the evolution of
sub-strategies in Figure 5. It can be explained by the dierent management styles and
the dierent underlying assets for dierent strategies. Indeed, there are lots of dierences
between EH: S-EB which outperforms all the other sub-strategies and more particularly EH:
SB which is the rare underperforming strategy since the subprime crisis. Outperformance by
the EH: S-EB strategy may be driven by exceptional pre-crisis performance and its resistance
to the subprime crisis. The poor performance of the EH: SB strategy may be explained by
the blooming pre-crisis market and the market recovery after 2009.
We also provide an overview of the time dependency of basic statistics in Figure 6 by
analyzing a 24-month rolling window. Thus, we notice that Macro is the most consistent
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Figure 4: Evolution of HFRI strategies
Figure 5: Evolution of HFRI sub-strategies
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Table 3: Statistics of HFRI strategies (January 2000 - June 2013)
Strategy SR MDD
1

2
HFRI 5.76 6.67 0.49 21.42 0.57 4.34
EH 4.98 9.03 0.28 30.59 0.40 4.89
ED 7.47 6.73 0.74 24.79 1.09 5.59
Macro 5.75 5.44 0.60 7.32 0.27 3.23
RV 7.13 4.41 1.06 18.04 2.83 18.92
is the annualized performance, is the annualized volatility, SR is the Sharpe ratio,
1
is the skewness,

2
is the excess kurtosis and MDD is the maximum drawdown over the entire period. All statistics are
expressed in percent, except for the statistics SR ,
1
and
2
.
strategy with the same level of Sharpe ratio and a low maximum drawdown whatever the
market regime. We also notice that RV has predominantly the best Sharpe ratio while the
performance of EH and ED is relatively poor.
Figure 6: Evolution of statistics for each strategy
2.2.2 Survivorship bias
As we explained in the previous section, the survivorship bias is linked to the fact that
failed funds are excluded from performance studies. Amenc et al. (2003) state that sur-
viving hedge funds seem to be hedge funds with better performance than the average of
the whole population since hedge funds with poor performance have to leave the industry.
Therefore, a database without dead funds leads to a higher performance estimate than the
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real performance of the hedge fund industry. It is only recently that a few hedge-fund
databases have maintained historical data on dead funds. It is partly for legal reasons and
partly because the primary users of these databases are investors seeking to evaluate existing
managers they can invest in. In the case where databases contain dead as well as live funds,
studies have concluded that the impact of the survivorship bias can be substantial.
Malkiel (1995) and Elton et al. (1996) estimate the survivorship bias for mutual funds
by comparing the dierence between average annual performances of all funds and surviving
funds and discover that the survivorship bias is much higher than estimated by Grinblatt
and Titman (1989). The survivorship bias in hedge funds is usually higher than in mutual
funds because of the higher turnover rate of hedge funds. Survivorship bias in hedge funds
is studied by Ackermann et al. (1999), Park et al. (1999), Brown et al. (1999) and Fung and
Hsieh (2000) and is estimated to be around 3% per year. Liang (2000) points out that the
dierence in estimated survivorship bias is due to the compositional dierence of databases
and dierent study periods. For example, the TASS database has a higher survivorship bias
than the HFR database because it has a default rate that is higher than HFRs. Ibbotson et
al. (2011) provide a more accurate estimate of survivorship bias of 5.13% per year without
the backll data which conrms the high survivorship observed by Aggarwal and Jorison
(2010). Eleanor Xu et al. (2011) study survivorship bias using a database from 1994 to 2009
but they do not nd survivorship bias to be notably signicant during the global nancial
crisis.
Survivorship bias makes risk management in hedge funds particularly challenging. Lo
(2001) shows that although this survivorship bias may not be too extreme for any given
fund, it aects the entire cross-section of funds and its impact is compounded over time in
the returns of each survivor, hence the end result can be enormous for the unwary investor
seeking to construct an optimal portfolio of hedge funds.
As we have a complete list of live funds in the HFR database at the end of June 2013, we
are curious to compare our equally weighted indices of these live funds with HFRI indices.
The evolution of equally weighted indices of these live funds compared to HFRI indices is
shown in Figure 7. The comparison of their basic statistics is given in Table 4. We observe
that, in general, live funds outperform all hedge funds by around 6% which is signicantly
higher than the level estimated using the database before the subprime crisis. Moreover, we
also observe that the performance of HFRI indices is more volatile than live funds. These
facts highlight the profound impact of the subprime crisis on the hedge fund industry.
2.2.3 Abnormal distribution and fat tail risk
According to Brooks and Kat (2002), any hedge fund strategy return distributions are not
normal and exhibit negative skewness and positive excess kurtosis. According to our basic
statistics previously presented in Table 3, it is especially true for all main strategies, except
Macro with a skewness of 0.27 and a positive kurtosis of 3.23. Thus, the majority of strategy
distributions are leptokurtic with fat left-tails. The probability of having extreme returns
is quite high, especially for negative returns. We conrm this result by estimating the
non-parametric distributions of the annualized returns of the four main sub-strategies. We
present them in Figure 8 and we notice that RV is the most leptokurtic strategy, Macro
shows an almost normal distribution while ED and EH are characterized by very fat left-
tails. These observations are consistent with the skewness and kurtosis statistics presented
earlier. The non-normal payos of hedge funds are due to various reasons such as the use
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Figure 7: Performance of live funds based indices versus HFRI
Table 4: Statistics of HFRI versus live funds based indices (January 2000 - June 2013)
Asset SR MDD
1

2
HFRI 5.76 6.67 0.49 21.42 0.57 4.34
EH 4.98 9.03 0.28 30.59 0.40 4.89
ED 7.47 6.73 0.74 24.79 1.09 5.59
Macro 5.75 5.44 0.60 7.32 0.27 3.23
RV 7.13 4.41 1.06 18.04 2.83 18.92
Live Funds 11.26 6.69 1.32 16.98 0.43 4.35
Live Funds: EH 11.00 9.24 0.93 26.79 0.56 4.37
Live Funds: ED 11.70 6.48 1.43 20.63 1.15 6.31
Live Funds: Macro 10.88 7.22 1.17 6.37 0.48 3.42
Live Funds: RV 11.72 4.81 1.93 14.85 1.55 12.08
of options or option-like dynamic trading strategies. One example of large losses by hedge
funds is the subprime crisis in 2008.
2.2.4 Performance persistence
Several authors (see e.g., Agarwal and Naik, 2000, Brown et al., 1999, Liang, 1999) inves-
tigate the performance persistence of hedge funds. Their objective consists in studying the
deltas between the return of single hedge-funds and the averaged return of all funds with
the same strategies. Performance persistence is dened by the fact that hedge funds which
outperform (or underperform) their corresponding strategies continue to outperform (or un-
derperform) over time. In other words, performance persistence corresponds to winners (or
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Figure 8: Non-parametric distribution of HFRI strategies
losers) continuing to be winners (resp. losers). According to Agarwal and Naik (2000),
performance persistence is higher for losers. Edwards and Caglayan (2001) nd evidence of
performance persistence over one- and two-year horizons among both successful and failed
hedge funds by using both non-parametric and parametric tests. This is conrmed by French
et al. (2005). Kosowski et al. (2007) and Jagannathan et al. (2010) who also conrm that
the abnormal performances are not only persistent in the short term but also in the case of
annual horizons.
2.2.5 Auto-correlation
Brooks and Kat (2002) state that the monthly returns of many hedge fund indices exhibit
highly signicant positive autocorrelation contrary to traditional assets. According to their
study, rst-order auto-correlation is most apparent for some strategies like Convertible Ar-
bitrage and Distressed Securities. They deal with dierent possible explanations. The rst
but not the most satisfactory one is that hedge fund strategies lead to returns inherently cor-
related to those of preceding months. Another more adequate explanation is liquidity bias.
As it is dicult to have up-to-date valuations of positions in illiquid securities, hedge funds
managers use last reporting valuations or an estimate which lead to lags in the evolution of
their net asset value.
With our selected HFRI indices, we do the same auto-correlation study. In Figure 9,
we present the corresponding correlograms taking into account 1 to 10 months of lag. To
complete this gure, we also provide auto-correlation values and their signicativeness in
Table 5. We observe that autocorrelations with a lag of one month are signicantly positive
at the 1% level except for the Macro strategy which exhibits the strongest autocorrelation
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with a lag of four months. For the ED and RV strategies, their autocorrelations remain
signicantly positive with a lag of more than one month.
Figure 9: Correlograms of HFRI strategies
Table 5: Autocorrelations of HFRI strategies
Strategy ACF(1) ACF(2) ACF(3) ACF(4) ACF(5)
HFRI 0.25

0.06 0.06 0.08 0.02


EH 0.22

0.05 0.07 0.08 0.07


ED 0.40

0.17

0.15

0.09 0.02
Macro 0.04 0.13 0.05 0.16

0.07
RV 0.55

0.24

0.16

0.07 0.04
, and denote signicance at the 10%, 5% and 1% levels respectively under the assumption that
returns are independent and normally distributed.
2.2.6 Cross-correlation with traditional assets
Some authors like Lhabitant (2006) report weak cross-correlation between hedge funds and
traditional assets. This characteristic is crucial for the risk diversication in portfolio allo-
cation with hedge funds. In the following section, we introduce nine traditional assets which
are used in the factor analysis of Fung and Hsieh (1997): cash (1-month eurodollar deposit),
commodities (Gold), currencies (Federal Reserves Trade Weighted Dollar Index), three eq-
uity classes (MSCI USA, MSCI World Ex USA and MSCI Emerging market) and three bond
classes (JP Morgan U.S. government bonds, JP Morgan Global Government Bonds Ex US
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and High Yield US Corporate Bond). To facilitate notation, we use the abbreviations given
in Table 6.
Table 6: Abbreviation of traditional assets
EQ US MSCI USA
EQ WLD MSCI WORLD Ex USA
EQ EM MSCI EM
BD US JPM US GOV BOND
BD WLD JPM GLOBAL BOND Ex US
HY BOFA US HIGH YIELD
USD US TRADE WEIGHTED
GOLD GSCI Gold
EUR 1M US EUROUSD 1M
The comparison between the basic statistics of HFRI indices and traditional assets is
shown in Table 7. We observe that hedge fund strategies generally have the best Sharpe ratio
because they combine high performance with low volatility. We also notice low maximum
drawdowns because hedge funds are less hurt by the subprime crisis relatively speaking,
compared to traditional assets. Then, in Table 8, we provide the cross-correlation between
traditional and alternative assets. We notice that HFRI indices and traditional assets are not
uniformly correlated. Some hedge fund strategies are more correlated to equities or bonds
than others. In our study period, EH and ED are highly correlated with equity assets.
Macro shows a positive correlation with BD US although other strategies have signicant
negative correlations. In addition, Macro has a signicant positive correlation with BD WLD
although other strategies have a more signicant correlation with HY. We also observe that
all the strategies have a low correlation with other traditional assets. Thus, hedge funds
allow diversication with respect to traditional assets. This can provide many benets in
portfolio allocation.
Table 7: Statistics of HFRI indices versus traditional assets (January 2000 - June 2013)
Asset SR MDD
1

2
HFRI 5.76 6.67 0.49 21.42 0.57 4.34
EH 4.98 9.03 0.28 30.59 0.40 4.89
ED 7.47 6.73 0.74 24.79 1.09 5.59
Macro 5.75 5.44 0.60 7.32 0.27 3.23
RV 7.13 4.41 1.06 18.04 2.83 18.92
EQ US 2.77 15.83 0.02 50.65 0.52 3.84
EQ WLD 3.17 17.99 0.04 56.34 0.67 4.36
EQ EM 7.77 23.89 0.22 61.44 0.53 4.08
BD US 5.83 5.02 0.67 5.34 0.22 4.18
BD WLD 5.58 8.51 0.37 10.24 0.10 3.18
HY 7.57 10.41 0.49 33.28 1.18 10.21
USD 1.51 7.06 0.56 39.29 0.14 3.09
GOLD 10.79 17.92 0.46 34.04 0.24 3.78
EUR 1M 2.47 0.61 0.00 0.00 0.61 1.93
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Table 8: Correlations of HFRI indices versus traditional assets
HFRI EH ED Macro RV
EQ US 0.76 0.78 0.75 0.17 0.60
EQ WLD 0.85 0.86 0.81 0.38 0.69
EQ EM 0.88 0.86 0.81 0.44 0.69
BD US 0.27 0.29 0.33 0.12 0.22
BD WLD 0.15 0.11 0.07 0.40 0.07
HY 0.70 0.68 0.77 0.17 0.78
USD 0.45 0.43 0.37 0.46 0.34
GOLD 0.29 0.26 0.18 0.46 0.21
EUR 1M 0.06 0.06 0.10 0.07 0.08
2.3 Quantitative classication of hedge funds
Previously, we presented the dierent qualitative classications with respect to databases in
Table 20 in Appendix A. These classications result from qualitative due diligence analysis
of providers. We notice that these classications are quite heterogeneous and it is dicult
to compare strategies between each database. Thus some questions arise: is qualitative
classication appropriate, and would quantitative analysis provide a better classication?
To the best of our knowledge, the rst research paper on quantitative classication of
hedge funds is Fung and Hsieh (1997). They use factor analysis and principal component
analysis to determine the dominant styles in hedge funds. They nd that approximately 43%
of the cross-sectional return variance of 409 hedge funds can be explained by ve orthogonal
principal components. Using the hedge funds most highly correlated with these principal
components, they construct ve style factors whose returns are highly correlated to the
principal components and compare the quantitative classication to qualitative classication
where the strategy is described in the hedge funds disclosure documents. Brown and Goet-
zmann (1997) also develop an alternative methodology: the Generalized Style Classication
(GSC) to identify asset management styles where asset weights vary over time. Brown and
Goetzmann (2003) nd that dierences in investment style contribute about 20% of the
cross sectional variability in hedge fund performance and argue that appropriate style anal-
ysis and style management are very important for investing in hedge funds. Dor et al. (2006)
analyze the risk/return characteristics of hedge funds using quantitative classication and
compare them to analysis using self-reported investment strategies of hedge funds. Gibson
and Gyger (2007) study the style consistency of hedge funds. Jagannathan et al. (2010) use
hedge fund style benchmarks to measure performance persistence.
In this section, we choose to apply principal component analysis to the HFRI indices
of 14 sub-strategies mentioned in Table 20 in Appendix A. The eigenvalues and cumulated
explained inertias are shown in Table 9. It is worth remarking that explained inertia by the
rst principal component is more than 50% and explained inertia by the rst ve components
is higher than 80%. The quality of representation is presented in Table 10. We observe that
all sub-strategies except EH: EMN, ED: PI, Macro and RV: FI-AB are best represented by
the rst principal component. The EH:EMN, ED: PI, Macro and RV: FI-AB sub-strategies
are best represented by the third, fourth, second and third component, respectively. The
contribution matrix given in Table 11 shows that the ED:DIS, RV: MS, RV: FI-C, EH:
QD and RV: FI-CA sub-strategies are the ve most important sub-strategies in the rst
component, the Macro, EH: S-TH, EH: SB, RV: FI-AB and EH: QD sub-strategies are the
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ve most important sub-strategies in the second component, the EH: EMN, RV: FI-AB, EH:
S-EB, ED: MA and EH: S-TH sub-strategies are the ve most important sub-strategies in
the third component, see Table 12.
Table 9: Eigenvalues and percentage of explained inertia by each component
Component Eigenvalue Percent of inertia (%) Cumulated percentage (%)
k = 1 7.07 50.53 50.53
k = 2 2.00 14.31 64.84
k = 3 1.32 9.45 74.29
k = 4 0.74 5.32 79.61
k = 5 0.62 4.41 84.02
k = 6 0.53 3.78 87.80
k = 7 0.45 3.19 90.99
k = 8 0.40 2.89 93.88
k = 9 0.27 1.90 95.77
k = 10 0.24 1.70 97.48
k = 11 0.12 0.84 98.32
k = 12 0.10 0.69 99.01
k = 13 0.08 0.54 99.54
k = 14 0.06 0.46 100.00
Table 10: Representation quality (in %)
Strategy k = 1 k = 2 k = 3 k = 4 k = 5 k = 6 k = 7 k = 8
EH: EMN 25.73 2.95 35.46 8.84 12.56 5.40 0.83 7.28
EH: QD 71.46 18.38 1.56 0.61 0.79 1.03 0.01 0.01
EH: SB 47.28 23.31 15.43 0.48 0.43 6.21 1.58 0.09
EH: S-EB 53.05 0.03 20.62 0.01 3.92 0.07 11.03 3.54
EH: S-TH 50.56 28.88 9.98 0.02 0.04 1.52 0.08 2.39
ED: MA 52.63 0.20 11.89 0.53 6.48 1.38 17.96 6.02
ED: PI 28.03 13.90 0.79 30.84 22.52 2.35 0.00 0.29
ED: DIS 79.87 2.71 0.22 0.25 1.32 0.06 0.43 0.20
Macro: SD 10.92 44.37 6.99 14.08 0.00 18.76 0.01 2.27
RV: YA 55.78 4.48 0.73 1.21 1.07 7.60 10.24 17.95
RV: FI-AB 21.80 21.38 24.93 12.76 6.77 5.69 0.05 0.15
RV: FI-CA 60.61 16.81 0.09 3.76 5.17 0.78 1.56 0.23
RV: FI-C 72.09 11.84 2.34 1.04 0.16 0.75 0.07 0.02
RV: MS 77.54 11.15 1.29 0.01 0.47 1.39 0.77 0.00
In this overview of hedge funds, we notice that the hedge fund industry represents a
heterogeneous asset class. Hedge funds have some general stylized facts: abnormal distribu-
tions and fat tails, performance persistence, auto-correlation and risk diversication benet.
We observe that dierent strategies exhibit dierent characteristics. Consequently, it is in-
ecient to consider hedge funds using a global index. It is more appropriate to distinguish
dierent strategies in asset allocation.
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Table 11: Contribution (in %)
Strategy k = 1 k = 2 k = 3 k = 4 k = 5 k = 6 k = 7 k = 8
EH: EMN 3.64 1.47 26.80 11.88 20.36 10.20 1.86 18.01
EH: QD 10.10 9.17 1.18 0.81 1.28 1.95 0.02 0.02
EH: SB 6.68 11.63 11.66 0.65 0.69 11.71 3.55 0.21
EH: S-EB 7.50 0.02 15.58 0.02 6.35 0.14 24.71 8.75
EH: S-TH 7.15 14.41 7.54 0.02 0.06 2.88 0.17 5.92
ED: MA 7.44 0.10 8.99 0.71 10.50 2.61 40.25 14.88
ED: PI 3.96 6.94 0.60 41.43 36.50 4.43 0.01 0.72
ED: DIS 11.29 1.35 0.17 0.34 2.13 0.11 0.96 0.49
Macro: SD 1.54 22.14 5.28 18.92 0.00 35.41 0.02 5.60
RV: YA 7.89 2.23 0.55 1.62 1.74 14.34 22.96 44.39
RV: FI-AB 3.08 10.67 18.84 17.15 10.98 10.73 0.11 0.38
RV: FI-CA 8.57 8.39 0.07 5.05 8.38 1.46 3.50 0.56
RV: FI-C 10.19 5.91 1.77 1.40 0.25 1.42 0.15 0.05
RV: MS 10.96 5.56 0.97 0.01 0.77 2.62 1.73 0.01
Table 12: Principal strategies in the three main components
1
st
component 2
nd
component 3
rd
component
ED: DIS Macro EH: EMN
RV: MS EH: S-TH RV: FI-AB
RV: FI-C EH: SB EH: S-EB
EH: QD RV: FI-AB ED: MA
RV: FI-CA EH: QD EH: S-TH
3 Investment vehicles
3.1 Single hedge funds and managed account platforms
A hedge fund is an investment structure which manages a portfolio of public and private
securities or derivative instruments, by using unconventional strategies. Its objective consists
in generating alpha using long positions, short positions and leverage. The hedge fund
manager determines its governance structure, the level of transparency towards investors
and selects the funds service providers. The management fee is proportional to the amount
of assets under management and the incentive fee is a percentage of prot when the fund
generates a protable return.
Several authors such as Anson (2006) provide a detailed presentation of the single hedge
fund and explain the interest of investing in it. Liang (1999, 2001) shows that hedge funds
are generally characterized by higher performance than conventional assets and mutual
funds. This is due to the skill of professionals, the use of leverage in risky investment
strategies and the exibility to invest in a wide range of instruments. Since hedge fund
performance is less correlated to traditional asset classes, hedge funds represent a new asset
class allowing investors to gain exposure to risks that are not correlated with the rest of their
portfolio. Nevertheless, the single hedge fund is not accessible to all: hedge fund selection is
a sophisticated process and due diligence takes time and eort. Investing in a single hedge
fund requires too much time and experience for investors. Moreover, the risks linked to
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hedge funds cover not only traditional risks but also management risk or transparency risk.
We can nd many studies on these specic risks of hedge funds, for example, Boyson (2003),
Foster and Young (2008, 2010).
Remark 1 Investors can invest in exchange quoted hedge fund companies to benet from
hedge fund performance. Apart from Man Group quoted on the London Stock Exchange since
1994, more hedge funds have been quoted on stock exchanges since October 2006, rstly in
the Netherlands, then in the UK and the USA in 2007. The largest funds such as Brevan
Howard, Winton Capital, Polygon and Och-Zi are quoted on stock exchanges based on a
fraction ranging from 10% to 30% of their capital, see (Teletche, 2010).
To facilitate the investment in hedge funds, some companies provide investors with a
managed account platform which is an investment structure run by the sponsor (including
the managed account provider, client and independent board of directors) to manage assets
by using transparent hedge fund exposures. The managed account can be fully customized
to the sponsors specic needs and restrictions. All operational aspects are handled by the
service providers chosen by the sponsor of the managed account. The managers are restricted
to managing the investors assets with the selected hedge funds. The sponsor chooses in-
dependent third-party providers to carry out certain operational tasks such as valuation or
accounting services and is responsible for the operational oversight of the managed account
(e.g. risk management, monitoring investment limits, cash management, reporting, legal,
compliance, tax, etc.).
Managed accounts have gained great popularity over the last decade or so. The ap-
peal of managed accounts lies in easier access to professional managers, a higher degree of
customization, better liquidity, greater transparency, more tax eciencies and stronger anti-
fraud ability than single hedge funds. Giraud (2005) argues that, thanks to independent
valuation and risk monitoring, managed account platforms oer a higher level of protec-
tion against potential fraudulent activities within a hedge fund structured around a private
partnership.
3.2 Funds of hedge funds and multi-strategy funds
A fund of hedge funds is an investment vehicle with exposures in several dierent hedge
funds. Its objective consists in capturing the performance of the hedge fund industry while
having better risk diversication than a single hedge fund. To do this, the fund of hedge fund
manager manages the selection of single hedge funds, portfolio construction and portfolio
management.
The added value of funds of hedge funds is the selection process used by single hedge
fund managers which enables investors to achieve good performance with diversied risks.
Due diligence and analysis of risks, correlations and behaviors are essential for the selection
process. Liang (1999) argues that funds of hedge funds oer investors greater returns than
mutual funds. Lamm (1999) shows that adding hedge funds to conventional portfolios
signicantly improves a portfolios risk-adjusted return performance via diversication and
low correlation with other asset classes. They state that portfolios of hedge funds are in
reality a conservative investment and can replace bonds and cash as a defensive vehicle when
equity prices decline. Gregoriou and Rouah (2002) outline the benets of including hedge
funds and funds of hedge funds in pension fund portfolios.
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A specic fund of hedge funds is the investable hedge fund index fund which selects funds
to deliver the performance of the reference hedge fund index. To construct an investable and
liquid index, hedge funds must agree to accept the terms including provisions for redemptions
that some managers may consider too onerous to be acceptable. Hence, investable hedge
fund indices do not represent the total universe of hedge funds.
Recently, some debates has occured on the representability and the eligibility for UCITS
III of investable hedge fund indices. Amenc and Martellini (2003) provide detailed evidence
of strong heterogeneity in the information conveyed by competing indices and attempt to
provide remedies to the problem suggesting a methodology designed to help build a pure
style index or index of the indices for a given style. Martellini et al. (2004) borrow
the concept of factor replicating portfolios from asset pricing literature and apply it to the
benchmarking of hedge fund style returns. Their results suggest that it is actually possible
to construct representative investable indices based on a limited number of funds, except
perhaps in the case of Equity Market Neutral strategy. Lhabitant (2006) argues that ex-
isting investable hedge fund indices are fundamentally dierent from indices of traditional
assets and they do not full the three basic criteria required to become UCITS III eligible -
sucient diversication, ability to serve as an adequate benchmark and appropriate publi-
cation, hence, he suggests excluding existing hedge fund indices from the list of UCITS III
eligible assets.
In spite of scepticism about their representability, investable hedge fund indices have
grown in numbers over the recent years and are widely available through a number of
providers, for example, HFR, S&P, FTSE, Dow Jones Credit Suisse (former CS/Tremont),
MSCI, etc. Lhabitant (2006) states that assets linked to investable hedge fund indices
exceeded USD 12 billion in 2006. Credit Suisse reports that aggregate assets under man-
agement of its investable hedge fund indices totalled to approximately USD 55 billion on
August 1, 2003.
The fund of hedge funds can be also regarded as a multi-manager fund which may
invest in a single strategy or multi-strategies. There are also multi-strategy funds which
are special single hedge funds diversifying risks in dierent strategies and often dierent
portfolio managers. Normally, multi-strategy funds cost slightly less than funds of hedge
funds but oer less exibility in portfolio allocation.
3.3 Hedge fund indices replicators
Instead of reecting the performance of actual hedge fund indices with the most represen-
tative exposures, a hedge fund indices replicator uses the statistical approach to replicate
hedge fund indices using various investable nancial assets. This method makes the index
investable and the replicated portfolio can in principle be very representative. A hedge
fund indices replicator is built on the research of Hasanhodzic and Lo (2007) who argue the
possibility of creating passive replicating portfolios or clones using liquid exchange-traded
instruments that provide similar risk exposures at lower cost but greater transparency.
In contrast to traditional investments such as stocks and bonds, hedge-fund returns have
more complex risk exposures that yield additional and complementary sources of risk pre-
mium. Amenc et al. (2007) suggest that it is only through the introduction of new adapted
econometric techniques allowing for a parsimonious statistical estimation of the dynamic
and/or non-linear functions relating underlying factors to hedge fund returns that hedge
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fund replication could be turned from an attractive concept into a workable investment
solution. Amenc et al. (2009) nd that going beyond the linear case does not necessarily en-
hance replication power and conrm the ndings in Hasanhodzic and Lo (2007) who explain
that the performance of the replicating strategies is systematically inferior to that of the ac-
tual hedge funds. Giamouridis and Vrontos (2007) nd that dynamic covariance/correlation
models construct portfolios with lower risk and higher out-of-sample risk-adjusted realized
return. Roncalli and Teletche (2007) investigate the implications of substituting standard
rolling-window regressions, which appear ad-hoc, with more ecient methodologies such as
Kalman lter. They show that shortfall risk seems less important than with hedge fund
indices and regression-based-trackers and propose a new breakdown of hedge fund perfor-
mance into alpha, traditional beta and alternative beta. Cazalet and Roncalli (2011) study
the application of shrinkage methods to improve hedge fund replication.
4 Benets and risks of hedge funds investments
Hedge funds are entering the mainstream because they introduce a compelling new money-
management paradigm which is embraced by many investors. Investors can gain many
benets from hedge funds that traditional assets cannot oer, for example, signicant risk-
adjusted return, diversication of risks and better resistance to market environments. Nev-
ertheless, we should be aware of the specic risks related to hedge funds investing including
market risk or management risk.
4.1 Benets of hedge funds investments
4.1.1 Signicant risk-adjusted return
Investors are always curious about whether hedge funds can oer signicant positive returns.
In order to answer this question, researchers apply dierent methods to look into the risk-
adjusted return of hedge funds. Ackermann et al. (1999) rst use a single-factor model
to estimate the alpha. They study a large data sample from 1988 to 1995 and nd that
hedge funds consistently outperform mutual funds. Edwards and Caglayan (2001) run a
multi-factor model to estimate the risk-adjusted excess returns of hedge funds. By studying
a sample of hedge funds during the 1990-1998 period, they nd that hedge funds on average
have signicantly positive excess returns equalling 8.52% annually and these returns have a
close relationship with the type of hedge fund strategies.
Fung and Hsieh (1997) explain that hedge funds often use derivatives and follow dynamic
trading strategies. Therefore, the traditional linear method may oer limited help with
estimating the performance of hedge funds. In recent studies, researchers begin to include
non-linear exposure to standard asset classes in new models. Fung and Hsieh (2004) use an
ABS (Asset-Based Style) model similar to the APT (Arbitrage Pricing Theory) risk-factor
model to study the performance of hedge funds. In the ABS model, three trend-following
risk factors, two equity-oriented risk factors and two bond-oriented risk factors have been
identied
3
. They nd that these seven hedge fund risk factors can explain the systematic risk
of hedge funds more meaningfully than the traditional linear regression model. In order to
investigate two major market shocks: the LTCM debacle (September 1998) and the Internet
3
According to the recent research of David A. Hsieh, he adds MSCI emerging market index as the
emerging market risk factor in the model.
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bubble (March 2000), they split the data period into 3 subperiods: Jan 1994-Sep 1998,
Apr 2000-Dec 2002 and Jan 1994-Dec 2002, and nd that three hedge fund indices (HFRI,
TASSAVG, MSCI) exhibit signicant alpha for all sub-periods. Ammann et al. (2011)
propose a factor model whose risk factors are selected using a stepwise regression approach
and compare it to the factor model proposed by Fung and Hsieh (2004). They estimate
the alpha of hedge funds using a rolling-window regression approach with the Lipper/TASS
database over the 1994-2008 period but they do not systematically nd the decreasing alpha
of hedge funds over time which is reported by Fung et al. (2008) and Zhong (2008) over the
1994-2004 period.
In order to solve the diculties in evaluating the signicance and persistence of hedge
fund returns, Kosowski et al. (2006) employ a robust bootstrap method and Bayesian
approach which were applied by Busse and Irvine (2006) to mutual funds in order to estimate
the performance of hedge funds. They conrm that the abnormal performance of top hedge
funds cannot be attributed to luck and that abnormal hedge fund performance persists at
annual horizons.
To study the signicant risk-adjusted return with HFRI indices, we rst compare the
performance of hedge funds during dierent periods to the nine traditional assets of Fung
and Hsieh (1997). We provide the corresponding statistics in Table 13. Before the subprime
crisis, the performance of hedge funds was better than equity and bond performance with
higher returns and lower volatility. However, during the crisis, most hedge funds suered
major losses except for the Macro strategy (including CTA, currency trading, etc.). Although
hedge funds withstood the crisis better than equities but less well than bonds (except high
yield bond), the performance of hedge funds after the crisis is not signicantly better than
before the crisis but remains attractive to investors since they outperform bonds and exhibit
lower volatility than equities. Roncalli and Teletche (2007) propose breaking hedge fund
performance down into cash, traditional beta, alternative beta and alpha. By applying their
method, we show the relative and absolute breakdown of excess returns in Table 14 and we
illustrate the results in Figures 10 and 11. We nd that the alpha of most hedge funds is
signicantly positive. But there are some dierences between strategies. Some of them are
characterized by a high relative percentage of alpha such as EH: S-TH, RV: FI-AB or ED:
MA, whereas others display a high level of beta such as EH: QD, RV: FI-CA or RV: FI-C.
4.1.2 Ecient diversication of risks
Apart from attractive risk-adjusted returns, hedge funds oer benets in terms of risk di-
versication when added to a traditional portfolio. Liang (1999) shows that hedge funds
have a higher eciency line than mutual funds, which contradicts the widely held view that
hedge funds are risky investments. Signer and Favre (2002) compare most of the existing
academic literature on the benets of hedge funds in portfolio construction. They nd that
the benets of hedge funds are justied by a shift in the eciency line in the mean-variance
environment which is a standard process in the traditional portfolio management theory.
Using the HFR database and historical data for equities/bonds, we present the shift of the
Markowitz ecient frontier by adding hedge funds to the traditional equity/bond portfolio
in Figure 12. We observe that including hedge funds in traditional portfolios improves the
risk/return prole. Since most hedge funds always have a signicant negative skewness (see
Table 13), some studies introduce new methods to evaluate the benets of hedge funds more
precisely. Signer and Favre (2002) propose a new risk measure (Modied Value-at-Risk) and
conrm that adding hedge funds oers benets in term of risk-adjusted returns with the new
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Table 13: Performance comparison between traditional assets and HFRI strategies
Period Asset SR MDD
1

2
0
1
/
3
1
/
2
0
0
0
-
0
5
/
3
1
/
2
0
0
7
HFRI 8.71 5.95 0.89 6.39 0.09 3.37
EH 8.24 7.88 0.61 10.30 0.44 5.11
ED 11.34 5.75 1.38 9.34 0.64 3.93
Macro 8.07 5.48 0.85 7.32 0.15 3.81
RV 8.91 2.09 2.63 1.29 0.03 3.10
EQ US 2.45 14.15 0.07 46.15 0.31 3.39
EQ WLD 7.38 14.17 0.28 46.77 0.59 3.19
EQ EM 13.30 20.49 0.48 47.76 0.50 2.75
BD US 6.14 5.02 0.54 5.34 0.73 4.07
BD WLD 5.90 8.22 0.30 10.16 0.31 2.78
HY 7.24 7.66 0.50 12.00 0.82 6.12
USD 2.24 6.40 0.88 28.92 0.04 2.80
GOLD 11.82 14.05 0.60 12.10 0.26 2.84
EUR 1M 3.41 0.56 0.00 0.00 0.27 1.57
0
6
/
3
0
/
2
0
0
7
-
0
4
/
3
0
/
2
0
0
9
HFRI 7.80 9.33 1.21 21.42 0.57 2.99
EH 12.09 12.71 1.23 30.59 0.48 2.97
ED 11.72 9.10 1.67 24.79 0.96 4.10
Macro 4.97 5.95 0.25 4.94 0.41 2.82
RV 5.83 8.80 1.06 18.04 1.51 5.35
EQ US 23.59 22.31 1.21 50.65 0.28 2.84
EQ WLD 26.73 26.94 1.12 56.34 0.35 3.05
EQ EM 20.56 37.83 0.64 61.44 0.33 2.77
BD US 10.15 6.84 0.98 3.67 0.26 3.31
BD WLD 9.71 10.77 0.58 10.24 0.17 2.71
HY 8.20 19.98 0.58 32.76 0.57 4.36
USD 0.26 8.53 0.44 12.24 0.55 2.79
GOLD 16.99 25.40 0.53 27.07 0.82 3.77
EUR 1M 3.48 0.51 0.00 0.00 0.15 2.16
0
5
/
3
1
/
2
0
0
9
-
0
6
/
3
0
/
2
0
1
3
HFRI 5.80 5.71 0.96 8.97 0.55 3.15
EH 6.00 8.18 0.69 13.17 0.65 3.56
ED 9.25 5.81 1.53 9.06 0.87 3.71
Macro 1.03 4.83 0.15 6.87 0.36 2.20
RV 9.35 3.65 2.47 4.06 0.84 3.83
EQ US 17.16 14.24 1.18 16.41 0.24 2.98
EQ WLD 8.87 17.78 0.48 22.39 0.36 2.93
EQ EM 7.81 20.42 0.37 25.59 0.09 3.12
BD US 3.91 4.00 0.89 3.30 0.26 2.83
BD WLD 2.55 7.89 0.28 10.10 0.63 3.71
HY 15.03 7.52 1.95 7.44 0.21 3.78
USD 0.68 7.15 0.05 13.67 0.23 2.72
GOLD 4.86 20.11 0.23 34.04 0.09 2.81
EUR 1M 0.33 0.03 0.00 0.00 2.04 8.20
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Table 14: Breakdown of the excess return of HFRI indices
Absolute Decomposition (%)
Strategy Traditional Beta Alternative Beta Alpha Excess Return
HFRI 2.46 0.64 0.73 3.82
EH 2.73 0.42 0.21 2.94
ED 2.97 1.19 1.31 5.47
Macro 1.66 1.91 0.65 4.22
RV 2.53 1.08 0.87 4.48
EH: EMN 0.03 0.56 0.17 0.75
EH: QD 3.74 0.90 0.43 4.21
EH: SB 1.82 1.39 0.99 4.21
EH: S-EB 5.20 0.39 0.52 6.12
EH: S-TH 2.04 0.44 1.21 2.81
ED: MA 1.70 0.10 0.74 2.33
ED: PI 1.18 0.20 0.40 1.78
ED: DIS 3.36 2.26 1.15 6.77
Macro: SD 2.19 1.72 0.62 4.53
RV: YA 2.61 2.15 1.29 6.05
RV: FI-AB 1.83 2.73 2.82 7.37
RV: FI-CA 2.83 0.91 0.19 3.94
RV: FI-C 3.07 0.78 0.34 4.19
RV: MS 1.93 1.33 0.51 3.77
Relative Decomposition (%)
Strategy Traditional Beta Alternative Beta Alpha Excess Return
HFRI 64.27 16.76 18.97 100.00
EH 92.77 14.29 7.06 100.00
ED 54.25 21.75 24.00 100.00
Macro 39.37 45.29 15.34 100.00
RV 56.48 24.16 19.35 100.00
EH: EMN 3.36 73.84 22.80 100.00
EH: QD 88.85 21.32 10.17 100.00
EH: SB 43.38 33.07 23.54 100.00
EH: S-EB 85.04 6.39 8.57 100.00
EH: S-TH 72.61 15.73 43.13 100.00
ED: MA 72.79 4.41 31.63 100.00
ED: PI 66.24 11.27 22.48 100.00
ED: DIS 49.63 33.32 17.05 100.00
Macro: SD 48.28 38.05 13.67 100.00
RV: YA 43.21 35.50 21.29 100.00
RV: FI-AB 24.77 37.04 38.19 100.00
RV: FI-CA 71.95 23.15 4.91 100.00
RV: FI-C 73.26 18.67 8.07 100.00
RV: MS 51.18 35.24 13.59 100.00
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Figure 10: Absolute alpha versus beta return for hedge fund strategies
Figure 11: Relative alpha versus beta return for hedge funds strategies
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risk measure. Daglioglu et al. (2003) reveal that adding hedge funds to a portfolio oers the
opportunity to invest wisely in new nancial products which are not available in traditional
investment vehicles and eectively reduces the portfolios volatility risk. Amenc et al. (2005)
show that investors may gain benets by adding hedge funds to their broad portfolio of as-
sets if the correlation between hedge funds and other assets in the portfolio is low. In order
to illustrate the benets of hedge funds in asset allocation, they compute ecient frontiers
in the mean return and modied Value-at-Risk plane. They state that adding hedge funds
with Global Macro, Event Driven and Long/Short Equity (Equity Hedge) strategies oers
signicantly high returns for a high level of risk and adding hedge funds with Equity Market
Neutral and Convertible Arbitrage largely reduces the portfolios risk level. Moreover, they
prove that hedge funds are diversication tools oering greater stability than international
equities.
Figure 12: Ecient frontier of portfolio diversied in each hedge fund strategy
In addition to the benet of introducing single hedge funds to a traditional portfolio,
funds of hedge funds can also oer risk diversication benets. In funds of hedge funds,
hedge fund selection is similar to a stock selection which aims to provide investors with an
extra level of diversication. There are two approaches to select hedge funds. The rst
approach is to selecting hedge funds over a wide range of strategies, managers, markets and
risk factors. The second approach is to invest in a large number of hedge funds with the
same strategy to avoid the risk of poor managers.
Ruckstuhl et al. (2004) state that the volatility in funds of hedge funds is lower than
traditional equities, that funds of hedge funds behave dierently from traditional equity
instruments and thus should be regarded as a separate asset class. Lhabitant and Learned
(2002) point out that the diversication in funds of hedge funds reduces volatility, but
10 15 hedge funds are enough to capture most of the diversication benets. French et
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al. (2005) report that funds of hedge funds hold 20 funds on average and returns by funds
of hedge funds are uncorrelated with the number of underlying hedge funds. Risk reduction
in funds of hedge funds is signicantly important. Total risk is reported as a function of
the number of holdings for four strategies (Equity Long/Short, Arbitrage, Event-Driven and
Distressed, and Global Macro) and the intra-strategy systematic risk of these strategies can
be reduced by around 40%-50% by using 15-20 funds. In Figure 13, we show the volatility of
an equally weighted portfolio of hedge funds as dependent on the number of selected funds,
thus conrming the ndings mentioned above.
Figure 13: Impact of diversication on volatility
Meanwhile, there is an over-diversication risk in hedge funds. For example, while single
hedge funds are not highly correlated with the index S&P 500, the correlation between a
portfolio of hedge funds and S&P 500 will tend to increase with the number of components.
Brown and Goetzmann (2003) argue that the accumulation of incentive fees for funds of
hedge funds will increase when more funds are selected in a fund of hedge funds because the
underlying funds will claim incentive fees based on their own performance regardless of the
performance of the fund of hedge funds. Brown et al. (2008) state that standard operational
due diligence provided by private due diligence companies costs a considerable amount on
a per fund basis. Since the cost of due diligence should be covered by the management fee,
there is an incentive for small funds of hedge funds to skip due diligence particularly when
its cost exceeds the management fees they can charge. Hence, it is reasonable to limit the
number of hedge funds in a portfolio.
4.1.3 Resistance to market environments
We investigate the performance of hedge funds in up and down markets. Daglioglu et al.
(2003) state that adding hedge funds to a portfolio enhances portfolio returns in economic
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environments in which traditional assets oer limited opportunities. Here, we choose the
traditional assets used by Fung and Hsieh (1997), see Section 2. As we can see before by
studying Table 13, hedge funds outperform equities and bonds before the subprime crisis,
they resist better than equities and less than bonds during the crisis, and then they remain
attractive. Then, we deal with resistance capacity by analyzing the performance of hedge
funds with respect to dierent environments. Indeed, for each of the nine traditional assets,
we build environments from 1 to 5 corresponding to the 5 quantiles of its return. Thus,
environments 1 and 5 respectively represent the period when the selected asset has the largest
losses or gains. We study the behavior of HFRI strategies in these dierent environments,
and results are shown in Figures 14, 15 and 16. It is interesting to observe that the amplitude
of hedge funds returns relative to the extreme performance of equities are much lower than
equities in Figure 14. Relative to the biggest loss by equities, hedge fund returns are on
average almost one third of the loss of equities, and Macro and RV have the best resistance.
In Figures 15 and 16, we nd that hedge fund returns are signicantly positive relative to
the biggest loss of bonds (except HY) and USD. While hedge fund performance is more
correlated to HY, hedge funds perform much better than HY in the worst scenario.
Figure 14: Average monthly return with respect to the environment factor (Equities)
4.2 Risks of hedge fund investments
While there are many benets in hedge fund investing, we should be also aware of specic
features of hedge funds as an unconventional asset. The hedge fund industry has received
tremendous attention over the past decade as an alternative investment strategy to improve
traditional portfolio returns. However, as a new investment strategy, there are new risks that
bear consideration. In this section, we present the essential risk factors that every investor
must confront when investing in hedge funds. We believe that an investor can structure
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Figure 15: Average monthly return with respect to the environment factor (Bonds)
Figure 16: Average monthly return with respect to the environment factor (Other)
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a successful hedge fund program if he can successfully manage the risks outlined in this
section.
Stevenson (2007) estimates that around 20 hedge funds collapse every year. The failure
of 60% of these hedge funds is due to operational risk (fraud and/or inadequate resources
and structure), in contrast, 40% of these hedge funds collapse as a result of investment risk
(e.g. market and/or investment management).
Feer and Kundro (2003) propose three basic risk categories of hedge funds: investment
risk (risks directly related to the market), business risk (risks related to fund management)
and operational risk (trade processing, accounting, administration, valuation and reporting
etc.). In our point of view, it will be better to classify the risks into two classes because hedge
fund failure is generally due to fraud or market risk. Since business risk and operational risk
proposed by Feer and Kundro (2003) are both related to the manner of fund management
but not directly related to the market, we propose to merge these two risks into an internal
risk category entitled management risk. In this way, we can easily classify the risks into two
classes: market risk and management risk.
The main risk of hedge fund investments is market risk which covers risks related to
market movements and includes event risk, credit risk and liquidity risk.
Tail risk Tail risk refers to the fat tail of the distribution of returns. Investors and fund
managers are more interested in downside tail risk which measures the risk of loss below
certain level, for example, three times the standard deviation. In the history of hedge funds,
the collapse of Long-Term Capital Management (LTCM) in 1998 and the subprime crisis
in 2007-2008 contributed greatly to the fat left-tail of the distribution of returns and have
driven investors to be more aware of tail risk.
Credit risk Counterparty credit risk is one of the most important risks for nancial in-
stitutions. Hedge funds interact with nancial institutions and intermediaries in many ways
including through prime brokerage relationships. These interactions extend counterparty
credit risk to hedge funds and other nancial institutions. In order to measure counter-
party credit risk under market uctuations, nancial institutions calculate potential future
exposure which is dened as the maximum exposure under a certain degree of statistical
condence and a future time period for counterparty credit risk management. Nevertheless,
unrestricted trading strategies, liberal use of leverage and lack of transparency make manag-
ing counterparty credit risk more dicult. Particularly, in a crisis, risks may be transmitted
from one institution to another by interlocking credit exposures. For example, the collapse
of Long-Term Capital Management (LTCM) in 1998 posed a systemic risk to the global
nancial system. Fortunately, regulations on hedge funds and counterparty credit risk man-
agement have been reinforced since 1998 and hedge funds now provide greater transparency
and more reports on their risk exposure.
Liquidity risk Liquidity is one of the main concerns of hedge funds. It refers to the risk
for hedge fund managers of clearing their positions and the risk for investors of exiting a
fund at the lowest cost as soon as possible. Sadka (2010) measures liquidity risk by the
covariation of fund returns with unexpected changes in aggregate liquidity and shows that
liquidity risk is an important determinant in the cross-section of hedge-fund returns.
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Remark 2 Besides market risk, we are well aware of management risk which covers the
risks related to internal management of hedge funds and includes transparency risk, oper-
ational risk and risk management risk. Transparency risk is related to the hedge funds
transparency reports compared to traditional assets. Operational risk includes the risks of
failure in internal operational, control and accounting systems, failure of compliance and
internal audit systems and failure of employee fraud and misconduct. Risks related to risk
management concentrate on the eciency of risk measures (e.g. VaR) for hedge funds due
to the specic heterogeneity of risks among various hedge funds.
5 Smart strategic asset allocation with hedge funds
Brennan et al. (1997) rst introduce the notion of SAA and Tactical Asset Allocation
(TAA) to describe long-term portfolio choice and short-term adjustment respectively. They
analyze the portfolio problem of investing in bonds, equities and cash with the presence of
time variation in expected returns on these asset classes. They found a signicant dierence
between the optimal portfolio using SAA and the optimal portfolio using TAA models. SAA
is formulated later by Campbell and Viceira (2002) and has gained popularity thereafter.
This long-term portfolio choice theory is becoming very attractive for long-term investors
such as pension funds or sovereign funds.
When investors want to build exposure to hedge funds in SAA, they must consider the
risk/return characteristics. However, standard mean-variance portfolio selection techniques
may suer from non-normally distributed (asymmetric and/or fat-tailed) hedge fund returns,
see Brooks and Kat (2002), Sornette et al. (2000), Amin and Kat (2003) and Cremers et al.
(2005). For that reason, a simple Markowitz mean-variance framework will probably lead to
inecient portfolio composition and an underestimate of tail risk. Hitaj et al. (2012) provide
the rst application of improved estimators for higher-order co-moment parameters intro-
duced by Martellini and Ziemann (2010) in the context of hedge fund portfolio optimization
and nd that the use of these enhanced estimates generates signicant improvement for
investors in hedge funds. Cumming et al. (2012) use normal mixture distribution to capture
the skewness and kurtosis of hedge fund returns. They show that the optimal portfolio
allocates nearly 20% to hedge funds in SAA. Eychenne et al. (2011) conrm the place of
hedge funds in SAA by using Markowitz mean-variance approach with a long-term forecast
of asset classes. The possible solution presented in this paper consists in getting rid of
the non-normality of hedge funds using a Markowitz mean-variance framework with regime
switching.
Moreover, in contrast to the appearance of performance similarity before the subprime
crisis, we should remember that hedge fund strategies can be very dierent one from another,
see Section 2.2. We observe that the hedge fund industry has changed profoundly since the
beginning of the crisis. The hedge fund industry has undergone a dicult period from the
end of 2007 to the beginning of 2009 after many glorious years. Since many studies on hedge
funds utilize hedge fund data prior to 2008 including performance similarity, it is no longer
credible to rely on these results to guide the future portfolio allocation. Thus, practitioners
should not consider hedge funds in SAA as a single asset class.
In what follows, we aim to propose an alternative allocation method to traditional SAA.
We start from the classical 2/3 1/3 asset allocation mix rule which is well known in the
industry and we try to improve it by introducing smart strategic asset allocation with hedge
funds. The philosophy behind this new strategy is that the dierent hedge fund strategies
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have signicantly dierent behaviors in terms of beta (equity/bond beta) and diversication.
Consequently, we propose to regard hedge funds with respect to their strategy as a diversier
or a solution for risk diversication and asset class exposure. The objective rst consists in
classifying hedge funds into the following three categories within the framework of SAA:
equity substitutes,
bond substitutes,
diversiers.
Then, in order to determine the long-term allocation, we consider that the stationary
long-run economic scenario is subject to two regimes: the extreme regime with high nancial
market stress and the normal regime with low nancial market stress. Thus, we distinguish
two types of allocation with respect to the forecast regime. We assume that the regime may
switch (or not) annually. In Table 15, we illustrate smart strategic asset allocation with
hedge funds versus the current solution. Smart strategic asset allocation with hedge funds
introduces hedge funds as traditional asset substitutes or diversiers.
Table 15: Smart strategic asset allocation with hedge funds
Current Solution
Equity
1
3
(1 x)
Bond
2
3
(1 x)
Hedge Fund x

Smart strategic asset allocation with hegde funds


Extreme regime Normal regime
Beta
Equity
Long-Only
1
3
(1 x
0
) y
0
1
3
(1 x
1
) y
1
Hedge Fund y
0
y
1
Bond
Long-Only
2
3
(1 x
0
) z
0
2
3
(1 x
1
) z
1
Hedge Fund z
0
z
1
Diversier Hedge Fund x
0
x
1
In this section, we present our results on smart strategic asset allocation with hedge
funds. First we dene three periods 01/31/2000 05/31/2007, 06/30/2007 04/30/2009
and 05/31/2009 06/30/2013. These periods represent the alternation between the normal
and the extreme regimes. Then, in addition to the study of alpha/beta breakdown of hedge
fund returns in Section 4, we present the beta corresponding to equities and bonds. Thus,
we determine the strategies which can be used as bond or equity substitutes and diversiers
and provide the basic statistics on these strategies. We then study the introduction of these
hedge funds in traditional SAA and we propose allocations with respect to economic regimes.
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5.1 Equity/bond substitutes or diversiers
In Section 4, we applied the method developed by Roncalli and Teletche (2007) to break
hedge fund returns down into traditional beta, alternative beta and alpha. The results are
presented in Figures 10 and 11 to illustrate the absolute and relative breakdown in alpha
and beta returns respectively. We observe that some strategies like EH: QD, ED: DIS,
Macro, RV: FI-CA, RV: FI-C and RV: MS can be strongly explained by beta (traditional or
alternative) although other strategies like EH: EMN, ED: MA and RV: FI-AB have returns
explained more by alpha. Thus, we can distinguish substitutes of traditional assets and
diversiers and select the following strategies for later study:
substitutes: EH: QD, ED: DIS, Macro, RV: FI-CA, RV: FI-C, RV: MS;
diversiers: EH: EMN, ED: MA and RV: FI-AB.
Then, we want to identify whether or not substitutes are equity or bond substitutes.
In Table 16, we present the value of equity and bond beta for all the HFRI strategies. A
comparison of appropriated hedge funds in term of equity/bond beta is illustrated in Figures
17, 18 and 19 with respect to the dierent economic regimes. We observe that the EH: QD
strategy always has the most signicant equity beta but some strategies such as EH: QD,
ED: DIS, Macro, RV: FI-CA, RV: FI-C and RV: MS have the highest bond betas. The
nal classication, with equity/bond substitutes and diversiers, is presented in Table 17.
It is interesting to compare them to the result of principal component analysis in Table 12.
We observe that the equity/bond substitutes are the main strategies in the rst and second
components and diversiers are the main strategies in the third component in the principal
component analysis.
Table 16: Equity Beta vs Bond Beta
Strategy
01/31/2000-05/31/2007 06/30/2007-04/30/2009 05/31/2009-06/30/2013
Equity Bond Equity Bond Equity Bond
Beta Beta Beta Beta Beta Beta
HFRI 31.42 15.57 32.64 3.43 32.47 2.65
EH 39.91 10.43 45.10 6.66 47.38 14.83
ED 27.62 28.23 34.14 2.57 32.51 4.64
Macro 15.90 39.34 14.33 28.94 10.31 24.35
RV 9.29 16.95 21.45 2.45 20.63 9.04
EH: EMN 1.69 7.41 10.79 17.15 14.32 10.16
EH: QD 78.19 5.82 61.19 5.88 44.02 2.88
EH: SB 84.52 55.75 48.22 37.31 65.24 16.70
EH: S-EB 37.40 59.05 59.64 39.77 65.55 18.59
EH: S-TH 74.09 24.26 53.09 16.22 38.04 35.49
ED: MA 14.10 16.36 18.46 4.75 8.97 4.55
ED: PI 0.00 0.00 0.00 0.00 0.00 15.63
ED: DIS 17.04 28.14 26.44 29.95 28.22 7.96
Macro: SD 44.98 15.78 23.09 8.63 6.98 0.00
RV: YA 18.46 32.38 25.95 12.10 33.48 9.56
RV: FI-AB 2.45 7.60 4.61 7.16 5.56 39.93
RV: FI-CA 3.14 16.74 26.85 16.89 32.20 2.00
RV: FI-C 12.00 26.61 18.95 39.10 20.15 14.66
RV: MS 7.86 24.25 18.47 5.38 20.76 20.01
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Figure 17: Equity Beta versus Bond Beta (01/31/2000 - 05/31/2007)
Figure 18: Equity Beta versus Bond Beta (06/30/2007 - 04/30/2009)
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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45 >>
Figure 19: Equity Beta versus Bond Beta (05/31/2009 - 06/30/2013)
Table 17: Equity/bond substitutes and diversiers
Substitutes
Diversiers
Equity substitutes Bond substitutes
EH: QD ED: DIS EH: EMN
Macro ED: MA
RV: FI-CA RV: FI-AB
RV: FI-C
RV: MS
5.2 How much should we invest in hedge funds?
Yin and Zhou (2004) introduced Markowitz mean-variance portfolio selection with regime
switching. Inspired by their work, we investigate the problem of asset allocation on hedge
funds with regime switching and assume that the economy is subject to two regimes: the
extreme regime and the normal regime. Let us denote the economic state of the year t by
s
t
:
s
t
=
_
0 if the economy of the year t is in crisis
1 otherwise
For each economic state, we will provide an allocation between three assets: equity, bond
and hedge fund. The objective is to introduce hedge funds using traditional 2/3 1/3 asset
allocation mix rule. In Table 15, we illustrate the expected smart strategic asset allocation
with hedge funds versus the current classical allocation.
Let us consider that assets have signicantly dierent annual performance and covariance
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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<< 46
matrices in the two economic regimes. We denote the asset performance vector in the regime
s
t
by (s
t
) and the covariance matrix in the regime s
t
by (s
t
). The transition probability
matrix between the extreme and normal regimes is denoted by Q where Q
i,j
represents the
probability that the economy switches from the regime i to the regime j. Dening Q
00
= p
and Q
11
= q, we can write the transition matrix as follows:
Q =
_
p 1 p
1 q q
_
Then, denoting the return of the k
th
asset in the year t by r
k
t
, we can dene a Markov
process as follows:
_
r
k
t
(s
t
) N (
k
(s
t
),
kk
(s
t
))
P[s
t
= j|s
t1
= i] = Q
i,j
In addition, it is not dicult to show that the steady-state probabilities for regime-switching
process s
t
are:
Q

=
_

0

1
_
=
_
1q
2pq
1p
2pq
_
Hence, we have:
E[s
t
] =
1 p
2 p q
where p and q can be calibrated by the EM algorithm for the hidden Markov model with
regime switching (Kim and Nelson, 1999).
Our objective is to determine the proportions of hedge funds x
s
t
, y
s
t
and z
s
t
denoted in
Table 15 in dierent potential economic states s
t
. Let us consider the allocation vector w
s
t
dened as follows:
w
s
t
=
_
_
_
_
_
_
1/3 (1 x
s
t
) y
s
t
y
s
t
2/3 (1 x
s
t
) z
s
t
z
s
t
x
s
t
_
_
_
_
_
_
In order to nd the optimal w
0
and w
1
allocations, we introduce a Markowitz-like opti-
mization program which consists in maximizing the expected performance of the portfolio
(w) under a constraint on the variance (w):
{w

0
, w

1
} = arg max (w) (1)
u.c.
_
_
_
(w)

0 w
0
, w
1
1

i
w
i
0
= 1 and

i
w
i
1
= 1
The above optimization problem can be resolved using a quadratic optimization program
shown in Appendix B. We then deduce the hedge funds proportions x
s
t
, y
s
t
and z
s
t
. In
order to invest reasonably in hedge funds, we limit the hedge fund allocation by 15%, saying
x
s
t
+ y
s
t
+ z
s
t
15%
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47 >>
By applying the EM algorithm to historical S&P 500 data, we obtain the following
estimated matrices:

Q =
_
0.87 0.13
0.57 0.43
_
and

Q

=
_
0.81
0.19
_
We consider EH: QD as an equity substitute, an equally-weighted portfolio of ED: DIS,
Macro, RV: FI-CA, RV: FI-C and RV: MS as a bond substitute and an equally-weighted
portfolio of EH: EMN, ED: MA and RV: FI-AB as a diversier. In Tables 18 and 19, we
present the basic statistics of equity, bond, equity substitute, bond substitute and diversier.
Table 18: Basic statistics - Equity/Bond Substitutes and Diversiers
Period Strategy SR MDD
1

2
Extreme regime
Equity 23.32 28.25 0.95 56.12 0.35 3.05
Equity substitute 12.45 13.06 1.22 31.12 0.29 2.41
Bond 4.14 8.51 0.08 11.13 0.23 4.68
Bond substitute 8.85 9.01 1.37 21.46 1.28 4.87
Diversier 1.70 3.20 1.62 5.90 0.57 3.10
Normal regime
Equity 11.38 16.72 0.66 21.48 0.24 3.17
Equity substitute 5.08 7.40 0.64 13.01 0.61 3.54
Bond 7.16 4.57 1.49 3.62 0.36 2.85
Bond substitute 8.31 4.47 1.79 6.10 0.46 3.34
Diversier 6.48 2.00 3.09 2.69 1.40 5.46
Table 19: Correlation matrix - Equity/Bond Substitutes and Diversiers
Period Asset Equity Equity sub. Bond Bond sub. Diversier
Extreme regime
Equity 1.00 0.95 0.73 0.79 0.74
Equity sub. 0.95 1.00 0.59 0.83 0.85
Bond 0.73 0.59 1.00 0.55 0.36
Bond sub. 0.79 0.83 0.55 1.00 0.89
Diversier 0.74 0.85 0.36 0.89 1.00
Normal regime
Equity 1.00 0.93 0.58 0.84 0.81
Equity sub. 0.93 1.00 0.43 0.80 0.82
Bond 0.58 0.43 1.00 0.61 0.48
Bond sub. 0.84 0.80 0.61 1.00 0.91
Diversier 0.81 0.82 0.48 0.91 1.00
In Figures 20 and 21, we present the optimization results with respect to risk appetite
parameter . Let us look at the evolution of optimal asset allocations with respect to
increasing risk appetite. According to the results, in the normal regime, investors with low
risk appetite have to manage their portfolio with the same allocation as in the extreme
regime where they use equity substitutes for some equities. Two thirds of the portfolio is
allocated to bonds, whereas the remaining third is equally exposed to equities and equity
substitutes. Investors with medium risk appetite prefer to reduce allocation to bonds and
equity substitutes. They also augment allocation to equities and introduce diversiers. In
their preferred allocation, diversiers completely replace equity substitutes. Investors with
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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Figure 20: Allocation strategy with respect to risk appetite - Extreme Regime
Figure 21: Allocation strategy with respect to risk appetite - Normal Regime
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Figure 22: Risk contributions with respect to risk appetite - Extreme Regime
Figure 23: Risk contributions with respect to the risk appetite - Normal Regime
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<< 50
high risk appetite prefer bond substitutes to diversiers, reduce the allocation to bonds and
increase exposure to long-only equities.
To conclude, in the normal regime, investors give priority to dierent families of hedge
funds according to their target portfolio volatility. If they have a low risk appetite which
corresponds to a target volatility below 6.5%, they prefer to invest in equity substitutes. If
they have a medium risk appetite which corresponds to a target volatility of between 6.5%
and 7.5%, investors prefer diversiers. With a high risk appetite and a target volatility of
over 7.5%, investors give priority to bond substitutes.
In Figures 22 and 23, we show the risk contribution of each asset in the two regimes
respectively. In the extreme regime, major risks are attributed equally to equities and
bonds. The risk contribution of equity substitutes is approximately equal to their exposure
in the portfolio. In the normal regime, we observe the evolution of the risk contribution
with respect to the increasing risk appetite. For investors with low risk appetite, the risk
distribution is almost the same as that in the extreme regime. In the portfolio allocation of
investors with medium risk appetite, we see a signicant risk increase in equities, meanwhile,
the risk of bonds decreases. It is interesting to note that the risk contribution of diversiers
is ve times lower than their exposure. For investors with a high risk appetite, the risk
contribution of equities increases slightly whereas the risk contribution of bonds is reduced
more signicantly. The risk contribution of bond substitutes is two times lower than their
exposure.
6 Conclusion
In this paper, we provide a short presentation of the hedge fund industry and a review on
its statistical properties. Hedge funds are attractive investment tools. Nonetheless, they
are more sophisticated than traditional assets, hence requiring greater investment expertise.
Using the HFR database, we present the detailed characteristics of hedge funds in this
paper: dierent biases of hedge fund databases, abnormal return distribution and fat tail
risk, performance persistence, signicant auto-correlation, weak cross-correlation between
hedge funds and traditional assets. We also apply principal component analysis to HFRI
indices in order to classify hedge fund strategies. With these analyses, we demonstrate that
hedge funds are heterogeneous and cannot be considered as a single asset class, especially
after the subprime crisis. Hence, it is no longer appropriate to follow the traditional approach
which considers the whole hedge funds as a separate asset class.
In addition, we also discover that hedge funds withstand a crisis better than traditional
assets. The other major benets and risks of hedge fund investing are summarized in this
paper. Nowadays, hedge funds remain attractive for a wide range of investors and are more
accessible than before through many investment vehicles such as single hedge funds and
managed account platforms, funds of hedge funds and multi-strategy funds as well as hedge
fund indices replicators. Many institutional investors use hedge funds in their strategic asset
allocation in addition to traditional assets.
Due to the signicant heterogeneity of hedge funds, we propose a new approach to
investigate the place of hedge funds in strategic asset allocation. We classify hedge fund
strategies in two families: equity/bond substitutes or diversiers. Equity/bond substitutes
are used to improve the risk/return prole of traditional assets (equity or bond) whereas
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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51 >>
diversiers are expected to provide absolute performance and diversication for traditional
assets. Moreover, to get rid of the non-normality of hedge funds, we apply a regime switching
Markowitz model to determine the optimal strategic asset allocation with hedge funds in
extreme and normal regimes. We nd that the optimal allocation in the extreme regime
includes equity substitutes, whereas, optimal allocation in the normal regime depends on
target volatility. Investors with a low risk appetite (target volatility below 6.5%) prefer
equity substitutes. Investors with a medium risk appetite (target volatility of between 6.5%
and 7.5%) are more interested in diversiers. If investors have a high risk appetite (target
volatility above 7.5%), they give priority to bond substitutes.
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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<< 52
A Comparison of classication in dierent databases
Table 20: Database classications
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HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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53 >>
B Markowitz mean variance model with regime switch-
ing
The rst step of the optimization (1) consists in nding simple expressions of (w) and
(w). It is easy to express the portfolio return r
t
(w) with the allocation vectors w
0
and w
1
:
r
t
(w) = w

0
r
t
(0)(1 s
t
) + w

1
r
t
(1)s
t
=
_
w

1
r
t
(1) w

0
r
t
(0)
_
s
t
+ w

0
r
t
(0)
where r
t
(0) and r
t
(1) are vectors of asset returns. We deduce that, under the long term
stationary distribution, the expected return of the portfolio is:
(w) =
_
w

1

1
w

0

0
_
E(s
t
) + w

0

0
(2)
Then, we deduce the standard deviation of the portfolio (w):

2
(w) = var
__
w

1
r
t
(1) w

0
r
t
(0)
_
s
t

+ var
_
w

0
r
t
(0)

+2cov
__
w

1
r
t
(1) w

0
r
t
(0)
_
s
t
, w

0
r
t
(0)

(3)
Besides, we have:
var
__
w

1
r
t
(1) w

0
r
t
(0)
_
s
t

=
_
_
w

1

1
w

0

0
_
2
+
1

i=0
w

i
(i)w
i
_
E(s
t
)
var
_
w

0
r
t
(0)

= w

0
(0)w
0
cov
__
w

1
r
t
(1) w

0
r
t
(0)
_
s
t
, w

0
r
t
(0)
_
= 2E(s
t
)w

0
(0)w
0
Hence, from Equation (3), we get:

2
(w) =
_
_
w

1

1
w

0

0
_
2
+
1

i=0
w

i
(i)w
i
_
E(s
t
) + [1 2E(s
t
)] w

0
(0)w
0
(4)
We can simplify Equation (2) and Equation (4) by using a matricial notation. By consider-
ing:
w =
_
w
0
w
1
_
, A =
_

1
_
, B =
_

0
0
_
,
C =
_
(0) 0
0 (1)
_
, D =
_
(0) 0
0 0
_
and E =
_
1 0
0 1
_
the equations (2) and (4) become:
(w) = w

(E(s
t
)A + B)

2
(w) = w

_
E(s
t
)
_
A

A + C
_
(2E(s
t
) 1) D

w
Then, we transform the optimization program in Equation (1) as follows:
w = arg min w

_
E(s
t
)(AA

+ C) (2E(s
t
) 1)D

w w

(E(s
t
)A + B) (5)
u.c.
_
0 w 1
w

E = 1
where is a risk appetite parameter of the investor. The above optimization problem is a
simple quadratic program and can be easily resolved.
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
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Lyxor White Paper Series
List of Issues
Issue #1 Risk-Based Indexation.
Paul Demey, Sebastien Maillard and Thierry Roncalli, March 2010.
Issue #2 Beyond Liability-Driven Investment: New Perspectives on
Dened Benet Pension Fund Management.
Benjamin Bruder, Guillaume Jamet and Guillaume Lasserre, March 2010.
Issue #3 Mutual Fund Ratings and Performance Persistence.
Pierre Hereil, Philippe Mitaine, Nicolas Moussavi and Thierry Roncalli, June 2010.
Issue #4 Time Varying Risk Premiums & Business Cycles: A Survey.
Serge Darolles, Karl Eychenne and Stephane Martinetti, September 2010.
Issue #5 Portfolio Allocation of Hedge Funds.
Benjamin Bruder, Serge Darolles, Abdul Koudiraty and Thierry Roncalli, January
2011.
Issue #6 Strategic Asset Allocation.
Karl Eychenne, Stephane Martinetti and Thierry Roncalli, March 2011.
Issue #7 Risk-Return Analysis of Dynamic Investment Strategies.
Benjamin Bruder and Nicolas Gaussel, June 2011.
Issue #8 Trend Filtering Methods for Momentum Strategies.
Benjamin Bruder, Tung-Lam Dao, Jean-Charles Richard and Thierry Roncalli, De-
cember 2011.
Issue #9 How to Design Target Date Funds?
Benjamin Bruder, Leo Culerier and Thierry Roncalli, September 2012.
Issue #10 Regularization of Portfolio Allocation
Benjamin Bruder, Nicolas Gaussel, Jean-Charles Richard and Thierry Roncalli, June
2013.
HEDGE FUNDS I N STRATEGI C ASSET ALLOCATI ON
I SSUE #11 - MARCH 2014 L Y X O R R E S E A R C H
61 >>
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R

F
.

(
B
)
7
1
3
9
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7

-

0
3
/
2
0
1
4