Paper
Journal of Derivatives & Hedge Funds (2007) 13, 88–106. doi:10.1057/palgrave.jdhf.1850066
Funds of funds versus simple portfolios of hedge funds: A comparative study of persistence in performance
Practical applications
Institutional investors can select hedge funds and construct their own FOFs rather than buying pre-packaged FOFs. We attempt to show that investors can avoid a second layer of management and performance fees, which can dig into performance, by showing that it is easy to construct simple equal-weighted portfolios of hedge funds whose performance characteristics dominate those of the largest fund of funds. We also highlight how investors can compare the performance of the two investment possibilities using three different measures: the alpha, the Sharpe ratio and the Information ratio. Finally, we reveal that there exists sufficient persistence in returns, especially for Non-Directional strategies, so that institutional investors can create simple portfolios of hedge funds that outperform the best FOFs based on all three measures.
Greg N Gregoriou1, Georges Hübner2, Nicolas Papageorgiou3 and Fabrice Douglas Rouah4
Correspondence: Greg N. Gregoriou, School of Business and Economics, State University of New York (Plattsburgh), New York, USA. Tel: +1 518 564 4202; Fax: +1 518 564 4215; E-mail: greg.gregoriou@plattsburgh.edu
1Greg N. Gregoriou is Professor of Finance in the School of Business and Economics at the State University of New York (Plattsburgh).
2Georges Hübner is the Deloitte Professor of Financial Management at the University of Lieége, Associate Professor of Finance at the University of Maastricht and academic expert at the Luxembourg School of Finance.
3Nicolas Papageorgiou is Associate Professor of Finance at HEC Montreal and co-director of DGAM-HEC Alternative Investment Research Center, Research Fellow at CIRANO and Research Associate at GREFI and at CIRPEE.
4Fabrice Douglas Rouah is Vice-President for a large financial institution based in Boston, MA.
Received 23 March 2007; Revised 23 March 2007.
Abstract
We construct simple portfolios of hedge funds whose performance characteristics dominate those of funds of funds using three different measures: the alpha, the Sharpe ratio and the Information ratio. Portfolios made up of non-directional funds with the highest Information ratios and/or Sharpe ratios are likely to exhibit a significant amount of persistence and continue to dominate the best funds of funds on all three performance measures. The large risk exposure of directional hedge fund strategies, however, makes them less likely to dominate funds of funds, even when combined with non-directional hedge funds strategies. Overall, these results seem to imply that the extra layer of fees paid to fund of fund managers are largely unmerited, as we can create portfolios of funds, using simple portfolio construction rules and readily available market information, that greatly outperform the best Fund of Funds.
Keywords:
funds of hedge funds, performance measures, selection, large funds, portfolio construction
