Place of hedge funds in a prudent portfolio: risk-return characteristics and performance evaluation

Agarwal, Vikas (2001) Place of hedge funds in a prudent portfolio: risk-return characteristics and performance evaluation. Doctoral thesis, University of London: London Business School.

Abstract

This dissertation analyzes the risk-return characteristics of hedge funds and conducts a detailed investigation of various issues related to evaluating their performance. The study uses a comprehensive database of hedge funds to make several contributions to the understanding of "black-box" of hedge funds. First, by using a multifactor model and mean-variance framework, the study aims to gain a more in-depth understanding of the different risk-return tradeoffs involved in investing in different hedge funds following directional and non-directional strategies. Second, by generalizing the style analysis technique developed by Sharpe (1992) that constrains the style weights to be non-negative, the study provides a better understanding of the significant risk exposures of hedge funds and examines their consistency with the stated objectives and classification of hedge funds. Third, the study investigates the issue of persistence in the performance of hedge funds specifically addressing the issue of horizon of persistence and the relationship between the performance fees, nature of strategy followed and persistence in a two-period and a multi-period framework. Fourth, it discusses the improvement in the risk-return tradeoffs obtained by including the hedge funds in a passive-only portfolio. For this purpose, it provides an empirical application of the theoretically justified gain-loss framework to deal with the issue of non-normality of hedge fund returns and compare the results of asset allocation and optimal portfolio choice with those obtained in the traditional mean-vari ance framework. Fifth, using a contingent-claim-based approach, it explains the returns of hedge fund strategies after accounting for their linear and non-linear risks. Finally, the study examines the relationship between characteristic features and performance of hedge funds. Overall, this study sheds light on various issues of interest to the investment community.