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Reducing the Risk in Hedge Funds of Funds

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READING, U.K. (–In one of his latest research papers, “In Search of the Optimal Fund of Hedge Funds,” Harry Kat concluded that the investor’s search is likely to continue for some time.

Mr. Kat’s definition of optimal has nothing to do with performance, though; he is strictly analyzing the skewness or risk of these funds. Skewness is the measure of the symmetry of an investment portfolio’s returns around its mean return. If a chart shows returns are skewed to the left of a portfolio’s mean return, it is said that skewness is negative, while if a portfolio’s returns are skewed to the right, they are said to have positive skewness and there is a higher probability that the portfolio’s returns will be greater than the mean return. In the case of hedge funds, negative skewness is often an issue, and hedge funds of funds are no exception. Mr. Kat, who is associate professor of finance at the University of Reading, decided to test two separate strategies for dealing with the specific skewness effect of hedge funds of funds.

The first strategy is one in which the fund buys stock index puts and leverages itself, but it is dependent on the actual asset allocation strategy followed by the investors to allow the fund construction to be optimal, according to Mr. Kat. But such a strategy has a limited applicability and for investors that invest more or less equal amounts in stocks and bonds and less than 30% of their portfolio in hedge funds.

The second strategy provides a less accurate type of skewness protection and is essentially a capital guaranteed product in its premise, which allows the fund to buy put options on itself. The variable seems to be the cost of buying such a put, which can differ considerably depending on the fund and the timing, according to the paper. Also stock index puts are easier to obtain than puts on a basket of hedge funds.

The strategies also differ in their risk profiles. The second strategy has a higher skewness, though both are low. Still their low risk profiles are accomplished in dissimilar ways in different portfolio allocations between stocks and bonds.

The moral of the research paper is not surprising, but Mr. Kat writes that, “…[funds of] hedge funds are primarily portfolio diversifiers and should therefore always be evaluated in a portfolio context and not in isolation.” And so the search continues.

In his conclusion, Mr. Kat questions whether a skewness-protected fund will ever hit the market but concedes that such an idea is in conflict with the current sales pitch that hedge funds offer investors absolute or market-neutral returns.

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