Building a Better Fund of Hedge Funds: A Fractal and Alpha - Stable Distribution Approach

Yan Olszewski

Finance from University Library of Munich, Germany

Abstract: Markowitz’s (1952) portfolio theory has permeated financial institutions over the past 50 years. Assuming that returns are normally distributed, Markowitz suggests that portfolio optimization should be performed in a mean-variance framework. With the emergence of hedge funds and their non-normally distributed returns, mean-variance portfolio optimization is no longer adequate. Here, hedge fund returns are modeled with the alpha-stable distribution and a mean-CVaR portfolio optimization is performed. Results indicate that by using the alpha- stable distribution, a more efficient fund of hedge funds portfolio can be created than would be by assuming a normal distribution. To further increase efficiency, the Hurst exponent is considered as a filtering tool and it is found that combining hedge fund strategies within a range of Hurst exponents leads to the creation of more efficient portfolios as characterized by higher risk-adjusted ratios. These findings open the door for the further study of econophysics tools in the analysis of hedge fund returns.

Keywords: hedge funds; fund of funds; portfolio optimization; conditional value at risk; alpha-stable distribution; Hurst exponent; fractals (search for similar items in EconPapers)
JEL-codes: C61 E17 G11 G23 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2005-07-19, Revised 2005-12-13
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-mac
Note: Type of Document - pdf; pages: 37
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0507018

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