Alternative Beta Strategies and Hedge Fund Replication

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Hedge Fund Portfolio Management withAlternative Beta Strategies

Armed with new knowledge about the possibilities and limitations of hedge fund replication, let us now look at portfolio management with a special emphasis on the value replication can add. We'll start by outlining the basic tasks facing hedge fund portfolio managers – strategy sector allocation, investment selection and risk management. Then we will examine the effect of adding replication strategies, to replace parts of a conventional hedge fund portfolio. This naturally leads to a ‘core–satellite approach’ to hedge fund portfolio management, which cost-efficiently combines alternative beta with manager alpha.

9.1 THE TASKS OF THE HEDGE FUND PORTFOLIO MANAGER

Like a mutual fund, a fund of hedge funds allows investors to diversify idiosyncratic (manager) risk. The average fund of funds displays a volatility of 5–7%,¹ compared with the average 8–10% volatility of single hedge fund strategies or the 15–18% of the average equity mutual fund. In addition to the natural diversification inherent in combining several hedge funds, ‘fund of funds’ managers provide the following key added value services:

1. Sector allocation. Top-down allocation to the various hedge fund strategies to allow investors to diversify across styles.
2. Manager allocation. Bottom-up selection of the best managers.
3. Post-investment monitoring and risk management. Monitoring the activities of hedge fund managers for unwanted risk.²

To deliver these services, ...