Hedge Fund Decomposition with Traditional and Alternative Investment Strategies
During 2008 financial crisis institutional investors such as pension funds, insurance companies, banks suffered large losses. Hedge fund also failed to provided uncorrelated to market returns at the time they were most needed. It has been over 10 years since financial crisis and the natural questions is whether financial industry well-equipped today should another crisis hit. With inherent complexity of financial products, it is challenging yet essential to effectively monitor the underlying risks of a portfolio. The motivation of this work is to create a simple tool that decomposes portfolio returns into investment strategies and with its help attempt to explain returns of hedge funds. The prototype of portfolio decomposition tool can be found on ShinyApps.io, also the source code can be downloaded from GitHub.
Portfolio decomposition into underlying risk factors is a standard approach to monitoring a portfolio risk. It allows to express the portfolio return as a linear combination of factor returns with coefficients (denoted beta), a constant term (denoted alpha) and a residual vector. Coefficients beta are exposures of portfolio to factors, alpha > 0 shows that portfolio outperforms a basket of risk factors, whereas alpha < 0 indicates that portfolio underperforms. The optimal coefficients can be found by minimizing standard deviation between portfolio return and a risk factor basket – the concept known in finance as a tracking error. Portfolio decomposition attributes variance of the portfolio to variances of individual factors and the remaining idiosyncratic (unexplained) variance component.
As a set of factors, we apply traditional and alternative investment strategies across multiple asset classes (equities, fixed income, FX, commodities, and volatility). Traditional strategies are defined as long-only investments (such as S&P500, US 10-year sovereign bond, etc.) and alternative strategies are defined as long/short investment strategies. The alternative strategies are divided into groups of Carry, Value and Momentum investment styles. Carry is earned when holding a high yielding asset and financing it with a low yielding asset, Value is associated with buying an undervalued and selling an overvalued asset based on a certain fair value matric. Momentum involves buying assets that appreciated and selling assets that depreciated over a certain time horizon (e.g. 12-month).
Hedge funds currently account for nearly $3 trillion in assets globally. They can be classified into equity long/short, event driven, global macro, relative value styles. In the analysis, we use Credit Suisse hedge fund indices that aggregate performance of underlying monthly hedge fund returns inside of each group. Also, we study returns of Credit Suisse Liquid Alternative Beta indices, which have daily returns.
Hedge Funds Decomposition with ShinyApp
Similar to ingredients in a recipe, hedge funds can also be broken down into its building blocks - underlying investment strategies. Portfolio Decomposition tab determines traditional and alternative investment strategies the portfolio is composed of and percentage allocations to them. Chart below shows an example of factor exposures generated by the app for one of the hedge fund indices .
Variance decomposition chart illustrates percentages of portfolio risk explained by each strategy and the remaining (idiosyncratic) component that cannot be attributed to considered factors.