Hedge funds are meant to be decorrelated from the markets. But this is only so on average. What, then, is the behaviour of a fund of hedge funds regarding particular market environments? We are basing our analysis on the SG Asset Management conservative flagship fund of hedge funds: SGAM Alternative Diversified Fund (SADF). After studying conditional correlations between SADF and the equity market, this article tackles the issue of allocation influencing performance.
We could have based our study directly on the funds of hedge funds performance but we have to take into account the market risk aversion commonly available through risk-less rates (as implemented in most of financial theories – for example, Black–Scholes)
Let us study the risk premium of a fund of hedge funds, which is to say, the spread between the fund of hedge funds monthly performance and the one-month US Libor. It corresponds to the risk reward for a fund of hedge funds shareholder with respect to risk-less assets or to the elementary arbitrage between investing in the risky asset (SADF) and the risk less one (one-month US Libor).
SG AM has built a non-linear factor model that enables to study the correlation between this risk premium and the market performance, differentiating for a bearish and a bullish market configuration. It allows us to analyse the historical fund pro-forma in order to understand the performance with respect to the economic environment.
The selected factor in this study is the stock market performance, measured by the monthly S&P 500 returns, which is the major reference for investors.
For the purposes of our analysis, we took the SADF monthly data between January 1993 and October 2002. Since October 2000 they are actual data and pro-forma prior to this date.
The market environment is identified by its bearish or bullish trends, defined in this article as follows: the trend is bearish if the value of the S&P 500 average for the last month is below the corresponding moving average over100 days; it is bullish, if the value of the S&P 500 average for the last month is above the corresponding moving average over 100 days.
In the graphs below, the horizontal scale shows the monthly yields for the S&P 500 and the vertical scale indicates the SADF risk premium for the corresponding month.

Results from the historical study
In bullish months, the SADF monthly premium increases linearly with the S&P 500 returns and varies between 0.5% and 1.7% for S&P 500 returns between –3.0% and 7.0%. Absolute variation is around 1.2%. We can see a stagnation of the monthly premium at 1.2% when the S&P 500 returns vary from 0.7% to 3.7%.
Usually, the SADF premium is quite low during S&P 500 bearish periods (between 0.0% and 0.90%), equivalent to an absolute variation of 0.9%. When the S&P 500 decreases from –6% to 2%, the SADF premium is close to 0%. Premium becomes positive when the drop goes faster (but limited at 0.2%) or during a bear rally (up to 0.80%).
This study enables us to see the ADF past behaviour in the context of the market environment. In a bullish market, the fund of hedge funds realises a good up capture. In bearish markets, funds of hedge funds have two characteristics: first, good capital preservation whatever the market situation, and second, the possibility of positive performance if there is a bear rally.
This study made us understand in which kinds of markets our management was efficient or not, and go further in improving the strategic and tactical allocation between the three main strategies. We defined them according to their performance to markets: Equity Hedge, Global Macro/CTA and Relative Value. What we call tactical allocation is the sub strategy management in each strategy. For example, in Relative Value, the allocation between Arbitrage, Distressed, Fixed Income or multi-strategies ; in Long-short, between Momentum, Discretionary and systematic, etc.

Impact of the reallocation: the results from the October 2002 allocation
These analyses made the strategic allocation evolve. Let us now study the October 2002 allocation using the same approach so that we can assess its gains and the new sensitivity analysis of our funds of hedge funds. We adjusted the portfolio to improve the bearish sensitivity of the fund of hedge funds. This analysis shows the objective achieved (see second set of figures. Moreover, the benefit is maintained in a bullish market.

Quant research gives better fund of hedge funds results
Our analysis model helps to better understand the behaviour of a fund of hedge funds taking into account the market environments and the benefits of the implementation of our allocation approach.
It allows us, in very difficult markets, not only to preserve the capital as we did this year but also to generate performances above the US Libor.
This approach shows that the quantitative research takes an important place in the funds of hedge funds management. The fund of hedge funds manager can implement his markets expectations and so understand the fund sensitivity to the market. It means that the quantitative research is embedded both in the validation and the implementation stages in the life of a fund of hedge funds.

Topics