In Search of the Optimal Fund of Hedge Funds

Abstract: In this paper we investigate whether it is possible for a fund of hedge funds to not only offer investors access to a diversified basket of hedge funds but to provide skewness protection at the same time. We study two different strategies. The first is for a fund to buy stock index puts and leverage itself, in line with the skewness reduction strategy proposed earlier in Kat (2002). In general, the latter strategy is too dependent on the actual asset allocation strategy followed by investors to allow a fund to be constructed that is optimal for all investors at the same time. However, for investors that invest more or less equal amounts in stocks and bonds and who keep their hedge fund allocation below 30% such a fund can indeed be structured. The second strategy is for a fund to buy put options on itself. We show that this does allow a fund to offer skewness protection to different types of investors at the same time, but compared to the optimal strategy the protection will be somewhat less accurate. Under both strategies the fund of funds is likely to incur a significant loss in expected return. As long as the hedge fund allocation stays below 30%, however, the loss of expected return on investors? overall portfolios will remain limited.