LO 71.7: Describe the historical portfolio construction and performance trend of

LO 71.7: Describe the historical portfolio construction and performance trend of hedge funds compared to equity indices.
Twenty-seven large hedge funds were identified in 2000, and research has been done to determine if these hedge funds are truly a separate asset class, not correlated to equity or bond indices. Hedge fund returns were regressed against an 8-factor model used to analyze hedge fund performance. Findings were that hedge fund portfolios had no significant exposure to stocks and bonds. As an equally weighted portfolio, this portfolio of 27 top performing hedge funds had a large alpha of 1.48% per month. There was a persistent exposure to emerging markets, but other factor betas showed a lot of variability. Also, alpha declined over time, and there was not a persistent directional exposure to the U.S. equity market. Measurement bias may have affected these results somewhat.
Alternatively, a strategy of investing in a portfolio of the top 50 large hedge funds was tested using data from 2002 to 2010. Two test portfolios were constructed: The first test portfolio attempted to mimic performance of a strategy of investing in the top funds in equal dollar amounts, and rebalancing at the end of each calendar year. The funds were selected based on the assets under management at year-end 2001.
A similar portfolio was constructed using top funds based on year-end 2010, rather than
2001.
For the first portfolio, the intent was to give a lower and upper bound of performance which investors could achieve, by just following a strategy of investing equally in the top 50 large hedge funds, and rebalancing yearly. The second portfolio was foresight assisted.
In evaluating performance characteristics, the first portfolio did not have a significant alpha, while the foresight-assisted portfolio had a monthly alpha of 0.53%, and was statistically significant at the 1% level. Compared to hedge fund returns prior to 2002, the decline in alpha is consistent with the thinking that there is more competition in the hedge fund industry. It should, however, be noted that there is no significant negative alpha.
Looking at the top 50 hedge funds versus all hedge funds, the top 50 portfolios (both versions) demonstrated statistically significant alpha relative to the DJCSI and HFRI hedge fund indices. The strategy of buying large hedge funds appears to deliver superior performance compared to just investing in hedge fund indices.
During the 2002 to 2010 time period, the top 50 hedge fund portfolios (with the exception of the foresight-assisted portfolio), and the two broad hedge fund indices, DJCSI and HFRI, all outperformed the equity market, as measured by the S&P 500 index. In sum, analysis of large hedge funds shows that managers are still delivering alpha return relative to peers, and also have low exposure to the U.S. equity market. These factors continue to attract institutional investors.
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
C o n v e r g e n c e o f Ris k Fa c t o r s