A Simulation-Based Methodology for Evaluating Hedge Fund Investments

Abstract

This paper introduces a large scale simulation framework for evaluating hedge funds’ investments subject to the realistic constraints of institutional investors. The method is customizable to the preferences and constraints of individual investors, including investment objectives, performance benchmarks, rebalancing period and the desired number of funds in a portfolio and can incorporate a large number of portfolio construction and fund selection approaches. As a way to illustrate the methodology, we impose the framework on a subset of hedge funds in the managed futures space that contains 604 live and 1,323 defunct funds over the period 1993-2014. We then measure the out-of-sample performance of three hypothetical risk-parity portfolios and two hypothetical minimum risk portfolios and their marginal contributions to a typical 60-40 portfolio of stocks and bonds. We find that an investment in managed futures improves an investor’s performance regardless of portfolio construction methodology and that equal risk approaches are superior to minimum risk portfolios across all performance metrics considered in the study. Our paper is relevant for institutional investors in that it provides a robust and flexible framework for evaluating hedge fund investments given the specific preferences and constraints of individual investors.

Keywords: large-scale simulation framework, hedge funds, optimal portfolios, risk parity, risk-based allocations

JEL Classification: G11, G17, C63