Hedge Fund Strategies, Performance & Diversification: A Portfolio Theory & Stochastic Discount Factor Approach
50 Pages Posted: 3 Jun 2019 Last revised: 23 Mar 2020
Date Written: March 20, 2020
For 5,500 North American hedge funds following 11 different strategies, we analyse the stand-alone performance of these strategies using a stochastic discount factor approach. Employing the same data, we then consider the diversification benefits of each hedge fund strategy when combined with a portfolio of US equities and bonds. We compute the out-of-sample Black-Litterman portfolios, with Bayes-Stein, higher moments and simulations as robustness checks. All but two hedge fund strategies out-perform the market as stand-alone investments; and all but one provide significant diversification benefits. The higher is an investor’s risk aversion, the more beneficial is diversification into hedge funds.
Keywords: Hedge funds, portfolio diversification, Black-Litterman, Bayes-Stein, stochastic discount factors
JEL Classification: G11
Suggested Citation: Suggested Citation