Fund of Hedge Funds Portfolio Selection: A Multiple-Objective Approach
Ryan J. Davies
Babson College - Finance Division
Harry M. Kat
City University London - Sir John Cass Business School
ISMA Centre, University of Reading
Cass Business School Research Paper
Journal of Derivatives and Hedge Funds, Vol. 15, No. 2, pp. 91-115, 2009
This paper incorporates investor preferences for return distributions' higher moments into a Polynomial Goal Programming (PGP) optimisation model. This allows us to solve for multiple competing hedge fund allocation objectives within a mean -variance - skewness - kurtosis framework. Our empirical analysis underlines the existence of significant differences in the return behaviour of different hedge fund strategies. Irrespective of investor preferences, the PGP optimal portfolios contain hardly any allocation to long/short equity, distressed securities, and emerging markets funds. Equity market neutral and global macro funds on the other hand tend to receive very high allocations, primarily due to their low co-variance, high co-skewness and low co-kurtosis properties. More specifically, equity market neutral funds act as volatility and kurtosis reducers, while global macro funds act as portfolio skewness enhancers. In PGP optimal portfolios of stocks, bonds, and hedge funds, where equity exposure tends to be traded off for hedge fund exposure, we observe a similar preference for equity market neutral and global macro funds.
Number of Pages in PDF File: 33
Keywords: Hedge funds, asset allocation, diversification, skewness, kurtosis, optimisation
JEL Classification: G11, G23, D81
Date posted: May 10, 2004
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