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CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition by CAIA Association

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38.4 FUND OF FUNDS PORTFOLIO CONSTRUCTION

Constructing a portfolio of hedge funds as an FoF may initially appear to be a very daunting task. Questions arise, such as: What are the top-down allocations to each strategy? Is this optimal? Are these strategies' definitions exhaustive? Where does one even start? Such questions are forever being debated within thoughtful FoFs. This section highlights some issues that may be encountered when portfolios are weighted using some overly simple allocation methods.

Unlike many standard allocation processes, employing AUM weights with the largest funds receiving the largest allocations may lead to suboptimal allocations. If hedge funds are earning alpha or excessive risk-adjusted returns when capital flows into a given hedge fund strategy, then under the backdrop of efficient markets, the alpha should eventually disappear. Following this reasoning, an allocation process whereby the largest allocation goes to the most popular strategies or the strategy with the most AUM may not be optimal. In fact, some FoFs even argue that a better approach would be allocating to hedge fund strategies in which flows are shrinking or receding.

According to the HFR Global Hedge Fund Industry Report, macro funds had the largest allocation of 39.30% in 1990, while event driven funds had the smallest allocation of 9.75% (with equity hedge of 37.07% and relative value of 13.88%). (See Exhibit 38.6.) In Q4 2011, macro funds had the smallest allocation of 22.07%, with ...

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