Funds of Hedge Funds or Investible Hedge Funds Indices: Which is the Best Investment Tool?

Hedge funds are becoming available to a broader spectrum of investors through funds of hedge funds and investible hedge funds indices. There is no official list of the strategies in use, but each database provider defines its own list, which which can have as many as 20 different strategies. This study aims at analysing hedge fund strategies, and determining how many different hedge fund strategies exist by analysing the correlation patterns among them. This study proves that investible hedge funds indices segregated per strategy are strongly correlated. We have also determined that the correlation between investible hedge funds indices is much higher than the average correlation between the individual funds of each hedge fund strategy. The aggregation of individual funds into indices diversifies the risk, but leads also to the loss of one of the major advantages of hedge funds, which is their weak correlation. Given that hedge funds indices are constructed on a fixed quantitative basis, a fund of hedge funds is the only vehicle that allows a trade-off between the number of funds to include a portfolio and the level of correlation, in order to reduce the risk inherent to hedge funds investments. As long as the fund of hedge funds double-fee structure does not impact its performance, and assuming that the fund manager structures its investment in such a way to keep a low degree of correlation between the fund of hedge funds and traditional financial assets, such investment represents the best alternative for a traditional investor to invest in hedge funds and improve the risk-return profile.