Thursday, February 4, 2016

Hedge fund value-added - dynamic conditional correlation tells a story

Hedge funds are supposed to hedge. This means that they generally will have low correlation with traditional assets and will have negative correlation especially during negative market moves. There are a number of ways to measure this effect including dynamic conditional correlation. This times series measure was developed as a means to account for the fact that correlations across assets are not stable. We will not go through the math but being able to account for changing correlation is extremely helpful when trying to build portfolios.

The simple hedge fund study "Reducing Stock Risk with Hedge Funds" by Ratner and Chiu does not show new results but provides some better insights on the value of hedge funds and portfolio construction. Hedge funds do have lower correlation with traditional assets as measured by the HFR fund of funds and fund weighted composite indices. There is no surprise here. The authors also find that hedge funds do not really hedge when extreme moves occur. Hedge funds get you some protection but not as much as you may like. The dummy variables to measure changes in correlation during periods of large stocks moves show no significance. There is no extra benefit. The authors also  there limited extra benefit during financial crises.  

 If you want to protect against a crisis or a large stock move, it requires a deeper dive into the specific strategies that could account for the protection. This is why we have divided the world into convergent and divergent strategies. If you want to protect against an extreme move or a crisis, just holding an alternative portfolio is not good enough. Strategies like managed futures or global macro which generate more positive convexity and do better in divergent environments are more helpful for investors. Those strategies that do better during periods of market convergent or mean reversion may add diversification benefits but may not do well in crises or market extremes. Knowing strategy differences  and why you want to hold alternatives make a big difference with portfolio construction. 

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