The Relative Merits of Investable Hedge Fund Indices and of Funds of Hedge Funds in Optimal Passive Portfolios

Jacques Pezier () and Anthony White ()
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Jacques Pezier: ICMA Centre, University of Reading
Anthony White: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: Can the new investable hedge fund indices (IHF) enhance the performance of optimal passive portfolios made of equities and bonds? How do they compare to funds of hedge funds (FoHF) as well as to other alternative investments such as commodities and volatility? The conclusions depend crucially on forecasts of future expected excess returns for all assets as well as a careful conditioning of the data to reflect trading costs and remove unrealistic serial correlations. A naïve forecast based on recent historical performance leads to no allocations to either IHF or FoHF, a result explained by the performance of equities and commodities and limited diversification effects from hedge funds. Yet a forecast based on market equilibrium returns for all main asset classes but hedge funds, which are kept at their historical level, leads to the opposite result with optimal portfolios almost exclusively invested in hedge funds. Both conclusions are unrealistic and unstable. More reasonable allocations are obtained with the Black-Litterman (BL) approach to combining subjective views with equilibrium returns. Then both hedge funds instruments play a significant role in optimal passive portfolios if their expected excess returns are at least 1%. Long volatility positions are also likely to be attractive. However the BL approach can also be criticised.

Keywords: hedge funds; investable hedge funds indices; funds of hedge funds; commodities; VIX; mean-variance analysis; Sharpe Ratio; Adjusted Sharpe Ratio; Omega Ratio; Black Litterman model (search for similar items in EconPapers)
JEL-codes: C53 G11 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2006-11
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Citations: View citations in EconPapers (15)

Forthcoming in Journal of Alternative Investments

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