Wednesday, December 10, 2008

Optimal Allocation to Hedge Funds

I've recently posted about the optimal portfolio choice between a global stock index and a managed futures fund. For this post I downloaded monthly return data from October 1996 to October 2008 for the Credit Suisse/Tremont Hedge Fund Index, which is an aggregate of many different hedge fund strategies. You can't actually invest directly in either index. This is in contrast to the managed futures analysis where the fund returns were after all fees and so the results are pretty realistic if the stock exposure occurred through a low cost index fund.

The hedge fund index yields 2.5% a year more than the stock index. So you'd want a fund of funds to cost less than that. Typical fees are 1% + a 10% performance fee. But the monthly standard deviation of the hedge fund index is 2.14% vs. 4.22% for the stock index. So it is possible to get a slightly higher return for less than half the volatility by investing in hedge funds instead of stocks.

The correlation between the two indices is 0.61 in contrast to the negative correlation between the managed futures fund and the stock index. This relatively high correlation and the higher returns of the hedge funds means that the optimal allocation is to invest only in hedge funds. Actually the Sharpe Ratio maximizing portfolio shorts stocks! The optimal share of stocks is -20% with 120% in hedge funds. This is the composite portfolio in the chart above. Borrowing one dollar for every dollar of equity results in a volatility about the same as stocks but with a monthly return of 1.37% vs. 0.58% for stocks and 0.79% for unlevered hedge funds.

Restricting the analysis to the period up till July 2007 only reduces the short position to 10%.

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