Funds of Hedge Funds or Investible Hedge Funds Indices: Which is the Best Investment Tool?

Abstract:     
Hedge funds are becoming available to a broader spectrum of investors through funds of hedge funds and investible hedge funds indices. There is no formal official definition of the strategies applied but each database providers defines its own strategies, which can count as much as 20 different strategies. This study aims at analysing hedge fund strategies and determining so many different hedge fund strategies that exists by analysing into details the correlation patterns that exists between theses strategies. This study proves that investible hedge funds indices segregated per strategy are strongly correlated. We have also determined that the correlation between investible hedge funds indices is much higher than the average correlation between the individual funds of each hedge fund strategy. The aggregation of individual funds into indices diversifies accordingly the risk but leads also to the loss of one of the major advantage of hedge funds, which is their weak correlation. Given that hedge funds indices are constructed on a quantitative basis, a fund of hedge funds is the only vehicle that allows a trade-off between the number of funds to include into a portfolio in order to reduce the risk inherent to hedge funds investments while keeping the correlation at a low level. As long as the fund of hedge funds double-fee structure does not impact its performance and considering that the fund manager structure its investment in such a way to keep a low degree of correlation between the fund of hedge funds and traditional financial assets, such investment represents the best alternative for a traditional investor to invest in hedge funds and improve its risk-return profile.

Keywords: Hedge funds, funds of funds, investible indices, performance, comparison, correlaiton, correlation coefficient, risk, return, traditional financial assets, alternative investments, risk-return profile

JEL Classifications: G2, G11, G15

Accepted Paper Series