Blog: Our Views on Risk Management and Portfolio Construction

Quantitative Perspectives on Alternative Investments - Why Conventional Approaches Fail

The TAA (Tactical Asset Allocation) framework implies constructing investment portfolios based on asset classes of underlying instruments and short-term performance forecasting of the corresponding indices. Originated from the traditional asset classes, TAA is often used for hedge FoF construction. However, when applied to alternative investments, it presents a highly misleading concept:

While everyone admits that hedge fund portfolio diversification reduces manager risk, the question of the optimal number of funds in a fund of funds (multi-manager portfolios) remains commonly overlooked. The typical mistake of misusing diversification derives from the classic standpoint that more funds in the portfolio ultimately enhances its diversification. This is not so.

Hedge fund portfolio optimization drastically differs from that of conventional asset classes. Applying the common asset optimization framework to hedge funds, usually leads to highly questionable results that only mislead an inexperienced investor. The main aspects of hedge fund portfolio optimization could be outlined as follows...

As it has become clear that hedge fund indices hardly provide a strong representation of single funds, we may ask the question: Why should this matter? How could the pitfalls and drawbacks of the index methodology affect the due diligence practice? The two following points explain this problem.

Although institutions have been conducting due diligence on investment managers for years, their routine protocols mainly focus on the qualitative side. Thus, the main drawback of commonly used due diligence frameworks is a lack of the quantitative component, arguably most important.

Over the last decade, we have been witnessing a degrading quality of large institutional investors including their own investment research and outsourced due diligence. That trend has become obvious after collapsing the giants like Lehman Brothers or Bear Stearns, however, its causes have never been investigated in details.

A sophisticated hedge fund due diligence framework should assess all applicable risks – not only their non-quantifiable segment. Our proprietary due diligence routine includes evaluation of the complete range of risk categories: Market, Liquidity, Volatility, Concentration, Strategy, Currency, Operational, Legal and Fraud risks.

The methodology of due diligence on hedge funds presents a controversial topic, mostly because of a strong qualitative bias of traditional institutional investors. Such a  bias leads to ignoring or underestimating most investment risks that have to be quantified. Our standpoint on due diligence could be summarized as follows...

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