Creating a Fund of Funds (FoFs) is predominantly being done on a bottom-up basis with top-down overlay conducted on the strategy level. The FoFs investment team usually formulate an outlook on the different strategies that they cover and from this make allocations to the hedge funds/strategies that are considered to best reflect their outlook. The portfolio construction is fine tuned by a discretionary call on the level of comfort of having different target weights for the different strategies, for example 35% in Equity Long/ Short, 15% in Event Driven, etc. In most cases FoFs have limits in terms of how much they can allocate to a specific strategy (as well as single manager).
An important aspect that is often forgotten in the portfolio construction process is that a lot of different strategies may be driven by the same underlying factors that lead to some groups of managers performing in a similar manner. The main reason for this may be that they use comparable trading styles and/or trade in related markets/instruments. Th fact that hedge funds are pursuing different strategies is not insurance that the returns they generate are not related in some way. There are numerous factors that influence the performance of FoFs and it can be hard to get a grasp of what these are by only analysing the aggregate return stream of the portfolio.
A useful tool in gauging these factors is Principal Components Analysis (PCA), a quantitative method that can be used to determine how many common factors influence the overall portfolio performance.It also highlights which managers affect which factors and to what extent. In addition, PCA can be indicative of the underlying diversification of a portfolio. Implicitly, it would be desirable for a portfolio’s returns to be driven by several drivers that are uncorrelated to each other as opposed to only one or two that are responsible for the bulk of the performance. The FoF manager can also gain insight into whether there are any underlying bets/tilts in the portfolio that are sub-optimal. This article goes through how PCA can be utilised in FoFs management to increase the knowledge of how the underlying funds interact. Emphasis is placed on the interpretation of PCA and less so on the underlying calculations.
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