Noël Amenc

Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques

In this article the authors provide a critical analysis of various methodologies involved in “passive replication” of hedge fund returns, a subject that has received renewed interest following recent initiatives by major investment banks. The authors examine from both theoretical and empirical perspectives the benefits and limits of the two different and somewhat competing approaches to hedge fund replication, respectively known as “factor-based replication,” and “payoff distribution replication.” The analysis suggests that only through the introduction of novel econometric techniques allowing for a parsimonious statistical estimation of the dynamic and/or non-linear functions relating underlying factors to hedge fund returns can hedge fund replication be transformed from an attractive concept into a workable investment solution. The authors conclude that hedge fund replication is still very much a work in progress.

Inflation-Hedging Properties of Real Assets and Implications for Asset–Liability Management Decisions

Recent increases in inflation uncertainty have increased investor awareness of the need to hedge against unexpected changes in price levels. Given that the capacity of the inflation-linked securities market is not sufficient to meet the collective demand of institutional and private investors and that the OTC inflation derivatives market suffers from a perceived increase in counterparty risk, investors are now turning to other asset classes to seek inflation protection. Using a vector error correction model that explicitly distinguishes between short-term and long-term dynamics in the joint distribution of asset returns and inflation, the authors show that real estate and commodities have particularly attractive inflation-hedging properties over long horizons and that these properties justify the introduction of these asset classes into pension fund liability-hedging portfolios. These results suggest that novel forms of liability-driven investment solutions, including commodities and real estate in addition to inflation-linked securities, can be designed to decrease the cost of inflation insurance for long-horizon investors.

Diversifying the Diversifiers and Tracking the Tracking Error:Outperforming Cap-Weighted Indices with Limited Risk of Underperformance

A number of quantitative or fundamental weighting schemes have been shown to produce robust outperformance with respect to standard cap-weighted equity indices over long time periods. Over periods ranging from a few months to a few years, however, such alternative weighting schemes can generate substantial downside risk relative to cap-weighted indices, which would be a source of concern for most investment managers or chief investment officers. In this article, the authors focus on two reasonable proxies for well-diversified, efficient frontier portfolios, namely, the maximum Sharpe ratio (MSR) portfolio and the global minimum volatility (GMV) portfolio. They address the question of how to use these building blocks to design an improved equity benchmark while satisfying target levels of average and extreme tracking error with respect to cap-weighted indices. The authors find that robust proxies for the GMV portfolio provide defensive exposure to equity that does well in adverse market conditions, while robust proxies for MSR portfolios provide greater access to the upside of equity markets. Because the relative performance of these two diversification approaches depends on market conditions, they expect a combination of both approaches to lead to a smoother conditional performance and higher probability of outperformance of the cap-weighted index, an intuition that is confirmed in empirical tests. Empirical analysis also suggests that “diversifying the diversifiers” still leads to high levels of relative downside risk, in particular when the performance of cap-weighted indices is unusually strong. In this context, the authors introduce an explicit relative risk control mechanism designed to reduce the consequences of severe short-term underperformance with respect to the cap-weighted index and confirm through out-of-sample empirical tests that “tracking the tracking error” would allow investors to achieve better access to outperformance per unit of extreme relative risk taken. Overall, the results reported in this article suggest that it is possible to achieve robust outperformance versus cap-weighted indices by diversifying model risk and by controlling relative risk compared to the cap-weighted indices.

Choose Your Betas: Benchmarking AlternativeEquity Index Strategies

This article clarifies that methodological choices can be made independently for two steps in the construction of alternative equity index strategies: the constituent selection and choice of a diversification-based weighting scheme. By flexibly combining the different possible choices for these steps, the authors create a large variety of strategies and test their performance and risk results. The results suggest that diversification approaches may be a superior alternative, or at least a very important complement, to pure stock selection approaches when it comes to reaching a risk–return objective. Moreover, even though some argue that the risk and performance of diversification-based weighting schemes are solely driven by factor tilts, the authors show how straightforward it is to correct such tilts through the selection of stocks with appropriate characteristics while maintaining the improvement in achieving a risk–return objective that is due to the respective diversification approaches.

Smart Beta 2.0

Alternative equity indexes are likely to outperform traditional cap-weighted indexes over the long term, research results show that such smart beta strategies are exposed to several types of risk, including systematic risk (e.g., factor tilts), specific risk (related to the assumptions and inputs of a strategy), and relative risk (i.e., the risk of potentially severe underperformance) compared to cap-weighted indexes that can last for extended periods of time. Smart beta can play an important role in institutional investors’ allocations, but only at the price of implementing a genuine risk-management process. This article discusses a new approach to smart beta investing (Smart Beta 2.0) that not only deviates from the default solution of using market capitalization as the sole criterion for weighting and constituent selection, but also analyzes and manages the risks of such deviations.

Practitioner Portfolio Construction and Performance Measurement: Evidence from Europe

Responses to a survey of investment management practitioners in Europe show that most practitioners are aware of key academic concepts in portfolio construction. But they still resort to ad hoc heuristics when they construct portfolios. Consideration of risk–return matters is less common in performance evaluation than in portfolio construction. An economically significant firm-size effect plays a role in the use of sophisticated (versus unsophisticated) portfolio construction but not in performance measurement. We surveyed 229 investment management practitioners in Europe for information on their methods of constructing portfolios and measuring performance. Our purpose was to assess the impact of academic finance research on investment industry practices. The responses show that most practitioners are well aware of key academic concepts in portfolio construction and frequently consider risk–return trade-offs. They often resort to ad hoc heuristics, however, when they construct their portfolios. For example, investment managers are aware of the importance of extreme risks, but the instruments they use to measure them are inadequate. To deal with estimation risk, practitioners use arbitrary weight restrictions rather than portfolio construction methods that explicitly address estimation risk. Responses relating to measurement of ex post performance show that risk–return considerations are less common in this area than in portfolio construction. Extreme risks are hardly taken into account in performance measurement, and adjustments for risk are crude. In general, practitioners use both sophisticated and unsophisticated techniques. When we analyzed the response patterns to determine what drives the differences in sophistication, we found an economically significant firm-size effect for portfolio construction. That is, response patterns from large institutions are markedly different from those from small institutions; small firms tend to use less sophisticated tools than large firms use. For performance measurement, we found a firm-size effect, but it is less pronounced than it is for portfolio construction. In view of the current failure of the industry to adopt sophisticated measures, one is compelled to wonder why investors do not demand better risk assessment in portfolio construction and performance evaluation. Some would argue that greater financial literacy of investors is key in improving matters; others would call for external regulators to mandate the use of appropriate risk measures. Although the evidence reported in this article does not allow us to take a stance on that issue, we believe that ensuring a sufficient transfer of knowledge about portfolio and risk management concepts from research results to practice is a necessary condition for sound investment processes in the industry.

The Performance of Characteristics-Based Indices

This paper analyses a set of characteristics-based indices that, it has been argued, outperform market cap-weighted indices. We analyse the performance of an exhaustive list of these indices and show that i) the outperformance over value-weighted indices may be negative over long time periods, and ii) there is no significant outperformance over equal-weighted indices. An analysis of the style and sector exposures of characteristics-based indices reveals a significant value tilt. When this tilt is properly adjusted for, the abnormal returns of these indices decrease considerably. Moreover, it is straightforward to construct portfolios with higher Sharpe ratios than characteristics-based indices through factor or sector tilts.

Revisiting Core-Satellite Investing

Tracking error is not necessarily bad. Good tracking error would be outperformance of a portfolio with respect to the benchmark. If they severely restrict the amounts invested in active strategies as a result of tight tracking error constraints, investors foreclose the opportunity for significant outperformance, especially during market downturns. A new methodology based on an optimal dynamic adjustment of the fractions invested in a passive core versus an active satellite portfolio allows investors to gain full access to good tracking error, while keeping bad tracking error below a given threshold. The method is a natural extension of constant-proportion portfolio insurance techniques.

Taking a Close Look at the European Fund of Hedge Funds Industry: Comparing and Contrasting Industry Practices and Academic Recommendations

Given the increasing importance of funds of hedge funds in the development of the hedge fund industry and the cost-intensive nature of multi-manager structures, investors are questioning whether FoHF add value to an extent that justifies the extra layer of fees induced by their activity. To answer these questions from a European perspective, Edhec Risk and Asset Management Research Centre carried out a survey of the practices of European hedge fund multi-managers. This survey focused on examining the following three dimensions that are commonly perceived as the main sources of added value by multi-managers, namely fund selection, asset allocation and portfolio construction, and reporting and investor information. The authors report the results of this survey and shed some light on the causes of the gap between practitioner and academic perceptions with regard to the approach followed by hedge fund multi-managers. They conclude that the institutionalization of hedge funds, and the move from absolute performance to diversification benefits, cannot simply be understood as a change in scale and client objectives, but more as a profound modification of investor requirements impacting several dimensions of the industry.

Tactical Style Allocation—A New Form of Market Neutral Strategy

Even though there is little evidence of predictability in stock specific risk, most equity market neutral managers still rely on stock picking as the preferred way to generate abnormal returns. In this article, the authors document the benefits of a new form of market-neutral portfolio strategy that aims at delivering absolute return over the full business cycle through systematic equity style timing decisions. Using a robust multi-factor recursive modeling approach, they find strong evidence of predictability in value and size style differentials. They use these econometric forecasts to generate systematic style timing allocation decisions. These portfolio decisions can be implemented using Exchange Traded Funds on US style indexes.