Constructing a diversified portfolio of managers in a fund of funds requires a method for determining how the different exposures complement each other.
Cluster analysis can reveal important insights into portfolio management behavior. Cluster analysis can supplement the classic tools of qualitative management interviews and this tool can, over time, help us to better understand a manager’s exposures and how a group of managers adapts to changing market opportunities.
During the last decade, funds of hedge funds have become increasingly popular with the investors who look to allocate capital to hedge funds, but do not have the resources to research, monitor, and manage a number of stand-alone hedge fund investments. Qualitative methods include in-depth interviews of the manager’s investment style and operations. Quantitative methods include the calculation of the Sharpe ratio and other performance measures, portfolio optimization, and analysis of the correlation matrix of returns.
Data and Methodology
During the last decade, funds of hedge funds have become increasingly popular with the investors who look to allocate capital to hedge funds, but do not have the resources to research, monitor, and manage a number of stand-alone hedge fund investments. Despite the fact that the fund of funds sector has been substantially affected by the current financial crisis, fund of funds’ investment in hedge funds still accounted for an estimated $606 billion of the $2.1 billion hedge fund industry at the end of the fourth quarter of 2009.
Dividing the world into specific investment strategies requires a well-established set of categories or factors that are easily identified and are known to be good predictors of the pattern of returns. In parts of the hedge fund universe these categories have been created and successfully implemented. Each fund style has three or four factors that explain a statistically significant portion of returns. These factors can be used to build replicating factor strategies at lower fee levels. Additionally, the returns of the replicating strategies can be useful to the fund of funds managers to measure the skill of hedge fund managers.
However, some strategies are heterogeneous, and organizing hedge funds into static groups may be problematic during periods of financial stress. Cluster analysis is especially useful for building peer groups and examining the change in strategies over time
Clustering Methods
Clustering methods can be divided into various groups based on their procedures for arriving at clusters and the criterion used to evaluate whether funds cluster together. The clustering methods can be divided into two main categories of hierarchal and nonhierarchical methods. Agglomerative methods and divisive methods are the two hierarchical clustering techniques. Agglomerative methods start with clusters consisting of individual managers and combine similar clusters until all funds are grouped in a single cluster. Divisive methods proceed in the opposite direction, starting with all funds in a single cluster and cleaving until each cluster contains a single fund. Nonhierarchical methods start with a fixed number of target clusters and attempt to group all funds into these target clusters.
It starts with each manager as its own cluster and then it joins two closest clusters into a new cluster with the difference between the managers defined as one minus the correlation. This process is repeated for new cluster and other cluster and process continues till we has most reflective of the data characteristics.
Each clustering method also requires a criterion for determining the similarity of funds so that funds can be clustered. Similarity measures depend on the types of input data and the goals of the clustering. For some characteristics, Euclidean distance measures can be used.
Clustering managers based on historical returns can supplement the information obtained from a qualitative review of the manager. Therefore clusters highlight which fund characteristics are most salient in understanding a strategy’s ability to diversify a portfolio.
Source:
Submitted By:
Madhumita Das
12089
SIBM Bangalore.
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