Hedge Fund Strategy Portfolio Contributions

Performance Contribution to a 60/40 Portfolio

What is the potential impact of adding a hedge fund allocation to the traditional 60/40 (stock/ bond) portfolio?

Consider a traditional 60%/40% portfolio. 20% allocation of a hedge fund strategy group is added to the traditional portfolio. The resulting allocations for the combined portfolio are:

$$ \text{Stocks}=(0.60 \times 100)+(0.20 \times 100)=48\% \\ \text{Bonds}=(0.40 \times 100)+(0.20 \times 100)=32\% $$

It is generally true that when a hedge fund strategy is added to a portfolio:

• Total portfolio standard deviation decreases.
• Sharpe ratio increases.
• The sortino ratio increases.
• Maximum drawdown decreases in about one-third of the combined portfolios.

Shows that hedge funds do the following to the traditional portfolio of bonds and stocks:

• Increase risk-adjusted return.
• Offer diversification.

Risk-Adjusted Measures of Performance

• Sharpe Ratio: Risk is defined as standard deviation and penalizes both upside and downside variability.
• Sortino Ratio: Risk is defined as downside deviation and penalizes returns that fall below an inevitable minimum acceptable return. This is particularly relevant for hedge funds because of the left-tail risk.

Impact of 20% allocations to various hedge fund strategies added to traditional 60%/40% portfolio.

$$ \small{\begin{array}{c|c|c|c} \textbf{High Sharpe} & \textbf{High Sortino} & \textbf{Comparatively Higher} & \textbf{Sharpe and} \\ \textbf{Ratios} & \textbf{Ratios} & \textbf{Sharpe and Sortino} & \textbf{Sortino Ratios} \\ & & \textbf{Ratios} & \textbf{Significantly} \\ & & & \textbf{Enhanced} \\ \hline \text{EMN} & \text{Event-driven} & \text{Event-driven} & \text{FoFs} \\ \hline \text{Systematic futures} & \text{EMN} & \text{Global macro} & \text{Multi-strategy} \\ \hline \text{Global macro} & \text{Systematic futures} & \text{EMN} & \\ \hline \text{Event-driven} & \text{L/S Equity} & \text{Systematic futures} & \end{array}} $$

Risk Metric: Standard Deviation (SD)

• FoFs
• EMN
• Dedicated short-biased
• Bear market-neutral
• Systematic futures

Explanation:

• The capacity of these strategies to reduce risk was found to be significant.
• Some of the strategies were found to improve risk-adjusted returns significantly.

Small positive impact on decreasing SD of returns for the combined portfolio

• Event-driven/distressed securities
• Relative value/convertible arbitrage.

Explanation:

• Event-driven/distressed securities: Take long positions in securities, and their outcomes can either be a success or a failure.
• Relative value/convertible arbitrage: Often relies on leverage, which can become a risk during market stress.

Risk Metric: Drawdown

• Drawdown: Decline in value of the portfolio from its highest point (high-water mark) to any subsequent low point until a new high-water mark is achieved.
• Maximum drawdown: The most significant decline in value from a high-water mark to a subsequent low point in a portfolio’s value.

Most Negligible Maximum Drawdown (Opportunistic strategies)

• EMN
• Global macro
• Systematic futures
• Merger arbitrage

Explanation:

• The conditional risk model can demonstrate that these strategies have a relatively low exposure to equity or credit risk during periods of market turmoil.
• They also have good liquidity.
• These strategies are an effective way to provide diversification in a traditional asset portfolio.

High Maximum Drawdown

• L/S Equity
• Event-driven/ distressed securities
• Relative value/ convertible arbitrage

Explanation:

• The conditional risk model can show that these strategies are highly prone to equity and credit risk during market crises.

Question

How do the Sharpe and Sortino ratios differ in measuring risk-adjusted performance, and in what context is the Sortino ratio considered a superior performance measure for hedge fund strategies?

1. The Sharpe ratio and Sortino ratio both penalize downside variability.
2. The Sharpe ratio penalizes only downside variability, while the Sortino ratio penalizes both upside and downside variability.
3. The Sharpe ratio measures risk as downside deviation, while the Sortino ratio measures risk as standard deviation.

Solution

The correct answer is B.

This accurately describes the difference between the Sharpe and Sortino ratios in measuring risk-adjusted performance.

A is incorrect. The Sharpe ratio penalizes upside and downside variability, while the Sortino ratio focuses on downside variability.

C is incorrect. The Sharpe ratio measures risk as a standard deviation, not a downside deviation.

Reading 38: Hedge Fund Strategies

LOS 38 (i) Evaluate the impact of an allocation to a hedge fund strategy in a traditional investment portfolio.