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EVALUATING GAINS FROM DIVERSIFYING INTO HEDGE FUNDS USING DYNAMIC INVESTMENT STRATEGIES
Niclas Hagelin and Bengt Pramborg
INTRODUCTION
For several years pundits have been proclaiming that alternative investments (and hedge funds in particular) deserve a place in investors’ portfolios. Notwithstanding the concerns of supervisory authorities on the level of sophistication required of investors to properly evaluate hedge funds, the weight of empirical evidence to date seems to support this salutary view. Hagelin and Pramborg contribute further to this evidence by evaluating returns to portfolios that include hedge fund investments, where the investor is assumed to allocate optimally among asset classes and to rebalance those allocations regularly.
Most interesting about the method they employ is that Hagelin and Pramborg do not assume that investors only care about expected return and standard deviation of return. This is important, since it has been well documented that hedge fund returns are not normally distributed.
Where standard portfolio theory assumes that investors care only about (or only have to care about) expected return and standard deviation, this paper allows that investors care about all the properties of asset return distributions. Hagelin and Pramborg follow a more general approach in which investors explicitly maximize their expected utility from investing in risky assets. They then show how this more general approach can be employed relatively simply in practice.
When the expected utility maximization apparatus is set into motion, the paper shows us at a fundamental level that investors will optimally choose to allocate wealth to hedge funds, even when they take into account deviations from normality in hedge fund returns. Hagelin and Pramborg also show that those optimal allocations result in portfolio returns that have, in some cases, statistically significantly greater returns compared to the case in which when hedge fund investing is not permitted. These results appear to be robust to a wide range of assumptions about the extent to with the investor is averse to risk.
As with any empirical study, the quality of the inferences that can be made are limited by the quality of the data employed. Hagelin and Pramborg remind us not to take the results of their paper completely at face value, because hedge fund return data is known to have a variety of deficiencies (biases). They look at the possible impact of some of those deficiencies on their results, and find that their results remain qualitatively intact.
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BIBLIOGRAPHY
- Ackermann C., McEnally R., and Ravenscraft D., 1999, "The Performance of Hedge Funds: Risk, Return, and Incentives", Journal of Finance, 54(3), pp. 833-874.
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http://www.GloriaMundi.org/picsresources/rb-sahk.pdf
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http://www.GloriaMundi.org/picsresources/rb-cbhk.pdf
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http://www.GloriaMundi.org/picsresources/rb-bgi.pdf
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http://www.GloriaMundi.org/picsresources/rb-bgl1.pdf
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http://www.GloriaMundi.org/picsresources/rb-glm.pdf
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http://www.GloriaMundi.org/picsresources/rb-nhbp.pdf
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ERRATA AND OTHER MATERIAL
- Other research by Niclas Hagelin:
SSRN website
- Homepage of Niclas Hagelin:
http://www.fek.su.se/home/nh/
- Other research by Bengt Pramborg:
SSRN website
- Related research
- Alexander, C. and A. Dimitriu, 2004, "The Art of Investing In Hedge Funds: Fund Selection and Optimal Allocations", working paper, University of Reading (January).
download (pdf 192K)
- Benedetti, S., 2004, "Hedge Fund Portfolio Selection With Higher Moments", masters thesis, ETH Zurich (December).
download (pdf 740K)
- Bacmann, J. and S. Pache, 2004, "Optimal Hedge Fund Style Allocation under Higher Moments", this volume, Chapter 14.
- Davies, R. J., H. M. Kat, and S. Lu, 2004, "Fund of Hedge Funds Portfolio Selection: A Multiple Objective Approach", working paper, University of Reading (July).
download (pdf 221K)
- Hagelin, N., B. Pramborg, and F. Stenberg, 2005, "Hedge Fund Allocation under Higher Moments and Illiquidity", in G. Gregoriou, G. Hübner, N. Papageorgiou, and F. Rouah, eds., Hedge Funds: Insights in Performance Measurement, Risk Analysis, and Portfolio Allocation, John Wiley, pp. 105–128.
buy at Amazon.com
- Harvey, C. R., J. C. Liechty, M. W. Liechty, and P. Müller, 2003, "Portfolio Selection with Higher Moments", working paper, Drexel University.
download (pdf 584K)
- Lee, B. and Y. Lee, 2004, "The Alternative Sharpe Ratio", this volume, Chapter 7.
- Sharma, M., 2004, "AIRAP: Alternative Views on Alternative Investments", this volume, Chapter 8.
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