In a new research report, Scope estimates the downside risk of portfolios of hedge funds, using past performance data to map the hedge funds’ performance to generic market indices. The study shows that asymmetric GARCH processes replicate the time evolution of these indices, and explains how they can form the backbone of a factor simulation. The resulting distributions capture the downside risk of portfolios of hedge funds in out-of-sample tests, even when only using the funds’ strategic classification.

Importance of estimating hedge fund returns and their dependencies 

Hedge fund returns and their interdependencies determine the performance of the funds of hedge funds. They are also the central factors driving the risk for collateralised hedge fund obligations (CFOs) and similar securitisations that were developed in the market in order to provide direct funding to hedge funds and alternative investment funds. These structures typically expose investors to market value risks related to the liquidation of fund shares to cover interest and principal payments to investors. Understanding the return distribution of the portfolio of hedge fund shares is therefore a central element of judging risks in CFOs.

Identifying the risk factors

Scope applied a new multipath search algorithm based on recent academic research to map hedge fund performance to market indices. The proposed set of indices includes standard market indices as well as indices developed especially by market participants and researchers in order to capture hedge fund strategies. Depending on the strategy of the hedge fund, the set of explanatory indices can vary substantially. The mappings show a clear dependency structure between the individual funds that can easily be replicated in a Monte Carlo simulation. The results of the study show that the derived mappings can be generalised and used to project hedge fund strategies onto the market indices.

Performance testing

In its research, Scope shows the results from out-of-sample tests for the dynamics of the individual indices, simulated strategies, and random portfolios of hedge funds. The proposed simulation approach reliably captures the downside risk of larger portfolios (about 10 assets), even during the financial crisis. For small portfolios (two to five assets), the simulation can occasionally underestimate the probability of a loss. In all cases, the simulated loss turned out to be higher than the observed portfolio losses in that period.

Download the full report: Simulating Hedge Fund Strategies: Generalising Fund Performance.
 

Analyst Conference Call

The report's lead author, Dr Bereshad Nonas, director at Scope Ratings, will present the new research in a telephone and web conference call on Wednesday, 7 June 2017.

Following a brief presentation, he will be available to take questions.

When: Wednesday, 7 June 2017 at 2.30 pm CET
How: Conference call and web presentation
Analyst: Dr Bereshad Nonas

Click here to register