PORTFOLIO CONSTRUCTION
Optimal. Bespoke. Efficient.
Successful hedge fund investment requires a diversified and well-constructed portfolio. Whether building a fund of hedge funds or a portfolio with hedge funds, an optimal hedge fund allocation requires extensive knowledge of each hedge fund strategy and a thorough understanding of the investor’s risk preference.
Knowledge is a prerequisite
We understand how hedge fund strategies interplay. Greenwich Alternative Investments has been researching and tracking hedge funds for almost twenty years and continues to manage one of the largest hedge fund databases in the world. Our analysts interact with thousands of managers every year and are among the most knowledgeable and experienced hedge fund specialists in the industry.
Risk requirements
Before determining the optimal allocation of the hedge fund portfolio, we start by understanding the investor’s objective and view of risk. For example, pension investors may be more concerned that the investment is in line with the liability structure of the plan and it complies with regulatory requirements. Some investors may view risk as the probability of shortfall below some benchmark level of return while others are more sensitive to the overall magnitude of the loss. For investors looking for diversification benefits, low correlation may be the most important. All portfolios constructed by Greenwich Alternative Investments are individually tailored to complement the individual investor’s investment objectives.
Optimization framework
GAI’s robust portfolio construction framework takes into account two very important facts: hedge fund return distributions are non-normal and different investors have different views of risk. Because this can lead to almost endless portfolio allocation possibilities, we incorporate multiple techniques to determine the optimal combination of underlying funds that are the most efficient and consistent the investor’s view of risk. We also perform optimizations that can take into account future views of expected returns as well as historical returns.
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Mean-variance optimization assumes hedge fund returns are normally distributed and volatility is the only source of risk. While this assumption is inappropriate for hedge funds, it helps investors understand the diversification effects of hedge funds in a familiar traditional framework.
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For investors who have their own definitions of risk and are more concerned with the downside volatility, optimization that minimizes downside deviation is appropriate. Here risk is calculated based on the magnitude of return short-fall below a customized threshold while the upside volatility is ignored.
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When the investor is more sensitive to the overall magnitude of loss, the optimizer that minimizes VaR is employed. Compared to the traditional mean-variance optimization, this optimization expands the risk spectrum from volatility to skewness as well as Kurtosis.
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When the investor prefers to incorporate their views about future expected returns, the optimization model that also takes into account the abnormality of hedge fund returns may be appropriate. For investors who don't have specific views but still want to use forward-looking returns in the portfolio construction, the forecasted returns generated from our proprietary factor models can also be used.
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Manager selection
Once the ideal strategy allocation mix has been determined, GAI screens managers in each strategy using the Greenwich Value Score. Only managers who are ranked in the top quartile within their strategies and pass GAI’s full due diligence are recommended for inclusion in the final portfolio.
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