Hedge Funds in Portfolios of Risk-Averse Investors

By Hood, Matthew; Nofsinger, John R. | Journal of Economics and Finance, Summer 2007 | Go to article overview

Hedge Funds in Portfolios of Risk-Averse Investors


Hood, Matthew, Nofsinger, John R., Journal of Economics and Finance


Abstract

We find that adding a hedge fund to an optimally weighted portfolio of stocks and T-bills generally increases the utility of an investor. From a sample of hedge funds with returns from 1996 to 2005, the certainty equivalent was an average of five basis points (monthly) higher with a ten percent allocation into a hedge fund. Funds from different style categories require different allocations into the stock market, but nearly all funds improved performance. Contrary to popular opinion, we find that highly risk-averse investors gain even more than less risk-averse investors by adding a hedge fund into their portfolio.

(JEL: G11, G23)

Hedge Funds in Portfolios of Risk-Averse Investors

The popular press gives investors the impression that hedge funds are a very risky investment class. The well-publicized, spectacular near-failure of Long-Term Capital Management, problems during the Asian financial crisis [see Liang (2001)], and fraud in the Bayou Group paints the picture of a maverick industry. It is an industry in which the U.S. Congress and the Securities and Exchange Commission have been considering more regulation [see Ip (2006)]. The Economist describes the hedge fund industry as having a "risk-taking culture" and recommends a change to attract and keep more institutional and risk-averse investors [see Special Report (2006)]. Indeed, the Financial Times reports that this change is already taking place, "[hedge fund managers] are increasingly refusing to make risky investments for fear of losing customers," Davis (2006). While acknowledging that hedge funds have significant risk exposure as a stand-alone investment, we demonstrate that they can be beneficial, improving the performance of a portfolio.

The benefit from adding a hedge fund into a stock and bond portfolio comes from the changing of the portfolio return profile rather than the absolute risk of the hedge fund. Fung and Hsieh (2002) argue that it is the differences in the investment strategies of hedge funds that add diversification value for investors. There are many different hedge fund categories of investment strategies to choose from, and both high and low risk-aversion investors may find hedge funds make good members of a portfolio.

We examine the relationship between an investor's welfare and level of risk aversion when allocating a portion of a stock and T-bill portfolio to hedge funds. Our procedure for this analysis starts by determining the optimal portfolios of stocks and T-bills desired by investors with different levels of risk aversion. We then add a hedge fund allocation and re-optimize the allocation to stocks and T-bills. The characteristics of the new portfolios are compared to the portfolio without hedge funds. We use the utility-based instruments described in the next section to avoid many of the problems associated with traditional performance measures and make comparisons for different types of investors.

Utility Instruments

The industry standard for comparing portfolio performance is the Sharpe ratio, a measure of efficiency or reward per unit of risk. A high Sharpe ratio indicates a valuable addition to a portfolio but does not measure improvement for the investor. Nor does it facilitate a discussion of the effects of the risk preferences of the investors. Therefore, to determine whether investors are better off wim a different portfolio we use certainty equivalents, CE. Sharma (2004) also discusses the certainty equivalent for evaluating hedge funds. By combining the certainty equivalent with the expected return we can also determine the direction the investor moves in return and risk. A portfolio can be shown to be better for the investor's utility and then it can be determined if the improvement comes from a reduction in risk, an increase in return, or both.

The certainty equivalent for any risky investment is the return, known for certain, that would leave the individual indifferent between the risky investment and the certain return, or utility(CE) = expected utility(risky investment). …

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