The Art of Investing in Hedge Funds: Fund Selection and Optimal Allocations

38 Pages Posted: 9 May 2004

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Peking University HSBC Business School

Anca Dimitriu

University of Reading - ISMA Centre

Date Written: January 2004

Abstract

With institutional investors increasingly involved in alternative investments, portfolio optimisation within a large universe of hedge funds has become a key area for research. This paper develops a portfolio construction model that is specifically designed for funds of hedge funds, incorporating specific controls for operational limitations, data biases and incompleteness. Absolute performance is targeted by selecting funds according to their alpha estimated with factor models. Whilst different factor models provide quite different estimates of a hedge fund's alpha, we can still use the ranking produced by them in the fund selection process. In an extensive out-of-sample historical analysis, funds of funds that are selected in this way and then allocated using constrained minimum variance optimisation are shown to perform much better than the equally weighted portfolio of all funds, or minimum variance portfolios of randomly selected funds. This is true even when hedge funds are selected according to their alphas produced by simple factor models. The best out-of-sample performance is obtained, out of the four factor models considered in this analysis, with the statistical factor model.

Suggested Citation

Alexander, Carol and Dimitriu, Anca, The Art of Investing in Hedge Funds: Fund Selection and Optimal Allocations (January 2004). Available at SSRN: https://ssrn.com/abstract=494404 or http://dx.doi.org/10.2139/ssrn.494404

Carol Alexander (Contact Author)

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.coalexander.com

Peking University HSBC Business School ( email )

Anca Dimitriu

University of Reading - ISMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

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