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Hedge Funds
Friday, December 1, 2006
How much is enough?

We have always been firm advocates of diversifying across asset classes within a portfolio. But the real question is, how much exposure should you have?

Take a particular alternative class of assets, hedge funds.
When does allocating to hedge funds not contribute positively to the risk adjusted return of a given portfolio?
Says Stephen Brierley, portfolio manager at Worldwide Capital, “There have been widespread research publications suggesting that hedge funds added to a stock, bond and cash portfolio improves the return with a less risk.” This may be particularly true with a well diversified and structured fund of hedge funds.
“After performing recent in-house analysis using a well diversified, low volatility local fund of hedge funds and a local and offshore hedge fund index, we reached some conclusions of our own. In each instance, using efficient frontier analysis, we added hedge funds to a portfolio of stocks, bonds and cash.
“By running several scenarios, each time limiting the maximum allowable allocation to each asset class, we discovered that in all cases, the efficient frontier model gave the maximum allowable allocation to hedge funds.”
Using a fund of hedge funds saw optimal allocation at anywhere between 20% and 30% in the portfolio, and using a local hedge fund index optimised allocation was between 20%-35%. Further allocation to hedge funds above these levels did not seem to add to the risk adjusted returns of the portfolio.
“In using the hedge fund index, some of the results were more pronounced than for the fund of hedge funds in that their addition increased performance by a greater margin with smaller amounts of risk or volatility,” he notes. “This could be explained by the fact that the index is far more diversified than the fund of hedge funds as it includes a larger number of funds.”
Analysis was also performed using a well known offshore hedge fund index and a portfolio of international stocks, bonds and cash. The results were fairly similar. A range of allocations up to a maximum of approximately 30% were tested, and represented graphically. The slope of the curve between the local and offshore portfolios was somewhat different, with the former recording a steeper slope initially and then smoothing out and the latter showing a smooth gradient throughout.
“Perhaps this is a result of the large differences between the volatility and returns of local and offshore hedges against other asset classes, with the local being more noticeable,” Mr Brierley suggests.
During this analysis, the same time periods were used for all asset classes in the portfolios. However, the time line for the indices was slightly longer than that of the fund of hedge funds.
“In summary, based on these results we believe that hedge funds do make investment sense in a portfolio and have a definite impact on the risk adjusted returns of such a portfolio.”
Footnote: It should be noted that hedge funds are currently unregulated in South Africa. Investors requiring more information about this asset class should seek advice from a licensed financial advisor.

Copyright © Insurance Times and Investments® Vol:19.6 1st December, 2006
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