hf-strategies - Quantitative Portfolio Strategy...

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Quantitative Portfolio Strategy Lehman Brothers October 11, 2005 Arik Ben Dor 212-526-7713 abendor@lehman.com Lev Dynkin 212-526-6302 ldynkin@lehman.com Tony Gould, CFA 212-526-2821 agould@lehman.com STYLE ANALYSIS OF HEDGE FUND RETURNS: ACTUAL VERSUS SELF-PROCLAIMED Introduction Institutional interest in hedge funds as an alternative to investments in traditional asset classes has increased substantially in recent years. Reflecting this trend, Lehman Brothers, in cooperation with HedgeFund.net (HFN), has recently launched a Global Hedge Fund Index. As with all benchmarks in the Lehman Brothers Global Family of Indices, the Lehman Brothers/HFN Hedge Fund Index is constructed using an objective rules-based set of criteria to determine index eligibility. 1 However, while other indices represent compos- ite returns of individual securities, the Hedge Fund Index reflects the performance of multiple investment strategies (or a single strategy in the case of style sub-indices) employed by the underlying funds. The minimal disclosure requirements hedge funds face, coupled with an investment mandate that typically allows them to use leverage, short selling, derivatives and highly illiquid securities, present serious challenges for investors. How should they assess the risk/return characteristics of a certain hedge fund strategy in the context of their overall asset allocation? What is the correct approach for comparing the performance (or alpha) of individual hedge funds within the same style? This article suggests one possible solution through the use of return-based style analysis, introduced in the early 1990s by William Sharpe and used primarily for analyzing mutual funds. This technique provides a way of identifying the asset mix style of a manager and comparing it with the asset mix style of a specified performance benchmark. We provide a short overview of style analysis and discuss how it may be extended to hedge funds with some modifications. We demonstrate how investors can use its results to better understand the nature of risks and exposures of various strategies, and the extent to which investments in various individual funds are correlated. Another application of style analysis is the construction of hedge funds portfolios. Lehman Brothers is planning to launch an investable index designed to closely track the broader index. Quantifying the sensitivities of individual funds to common market factors can be used to construct such investable indices in an efficient manner. Alternatively, it may be used to find the composition of portfolios with a minimum volatility for a pre-specified level of expected return. We also examine the common practice of classifying hedge funds into styles based on their self-reported investment strategy. The actual style of a fund may differ from its self- proclaimed because a style may not be uniquely defined or because the information reported by the fund may be inaccurate. We present a simple technique that can help Quantitative Portfolio Strategy PLEASE SEE IMPORTANT ANALYST CERTIFICATIONS ON LAST PAGE.
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hf-strategies - Quantitative Portfolio Strategy...

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