FUNDS OF HEDGE FUNDS

When great minds dont think alike

As investors view hedge fund risk more elegantly, cluster analysis helps evaluate fund of hedge funds portfolios, as Asset Alliances Daniel Axmer shows
Many funds of funds (FoFs) divide hedge funds into classification systems based on the strategy they pursue, but increasingly the many styles and strategies makes it harder to fit managers into existing classification systems. One way to deal with this is to increase the number of strategy segments in the portfolio. Sometimes this can give a false sense of security that the portfolio is well diversified as in reality strategies are more closely related than it might appear. One method that can be helpful to FoFs managers to construct strategy groups is cluster analysis. Cluster analysis is a statistical/mathematical technique used to divide similar objects into relatively homogenous groups and dissimilar objects into different groups, applied in a range of different research areas like medicine, marketing, psychology and economics. There are numerous benefits of using cluster analysis in FoFs management. It can be useful to determine objectively how many independent strategies exist in a portfolio and which manager belongs to which segment. Intuitively, we would expect managers that follow different strategies to be in different clusters. However, by grouping the managers in clusters we can see which managers are related to each other and which are not, regardless of the predetermined classification. Instead of taking strategy classification for granted it can be more useful to base classification on managers actual track records. Another application of cluster analysis is in portfolio construction. Creating portfolios with many assets generally leads to extreme solutions and/or suboptimal portfolio diversification. By using the cluster groups returns we reduce the instability of the optimisation process. It can also give us broad guidelines where to allocate capital given our overall risk/return objective. Cluster analysis can also be helpful when trying to find a benchmark for a manager, or developing a peer group. It can also be used to build indices, evaluate style consistency, conduct replacement analysis and transparency checks. Here, I create a hypothetical portfolio of hedge funds, assess how they relate to each other, evaluate why managers pursuing the same strategy end up in different groups and look into possible diversification benefits of allocating to different clusters.

CLUSTER ANALYSIS THEORY

Cluster analysis seeks to minimise differences between managers within each cluster and maximises the differences between managers in different clusters using hierarchical clustering, a technique that groups managers by creating a multi-level tree structure. To find the similarity or dissimilarity between the managers, a measurement of distance between the managers returns has to be selected. In this article, I use the Manhattan method. The equation for Manhattan distance is:

APPLICATION AND INTERPRETATION

A sample of 30 managers representing six different strategies is used to construct the hypothetical FoFs portfolio. The manager classifications and the data are collected from one of the largest managed-account platforms. The funds are classified by the following strategies: convertible bond and volatility arbitrage, CTA, event-driven, fixed income arbitrage, global macro and long/short equity.The data used is five years of monthly net returns (June 2000May 2005). If a fund has insufficient performance data for the managed account, the track record of the flagship fund is used to back-fill returns. The dendrogram indicates that there are four different groups in this portfolio, CTAs, macro/credit, equity/event and a cluster featuring the convertible bond (CB) and volatility arbitrage managers plus a couple of other managers, which can be called CB/Mixed. Table 1 below shows the overlaps and difference between the managed-accounts classification and the cluster analysis classification. The CTA cluster is the only cluster exactly the same as the managed-account classification. The main reasons for this are, the CTA managers have a similar risk/return profile and high correlation within the group. It is evident from the graph that CTAs are the most different of all clusters since it is the last group to link up

dij = rik rjk

k =1

To divide the managers the agglomerative method is used, which begins with each manager being its own cluster and then building up the links with the other managers until all managers end up in one large cluster. Finally, when all managers have been assigned to a cluster, we must determine how the different clusters relate to each other. Using the complete linkage method, this is calculated by taking the greatest distance between two managers in two different clusters. The output from the hierarchical method is portrayed in a cluster tree called a dendrogram. The objects are listed on the vertical axis and distances on the horizontal axis. (See below)
CTA 4 CTA 3 CTA 2 CTA 1 Macro 4 Macro 2 FI Arb 2 FI Arb 3 FI Arb 1 Equity 3 Macro 1 Equity 2 Equity 7 Equity 1 Event 4 Event 2 Equity 5 Equity 4 Equity 6 Event 5 Event 1 Event 3 Equity 8 FI Arb 5 FI Arb 4 Macro 3 CB & Vol Arb 3 CB & Vol Arb 4 CB & Vol Arb 2 CB & Vol Arb 1 0.5 1 1.5

2.5

Table 1: Cluster analysis classification CB/mixed cluster CB & vol arb 1 CB & vol arb 2 CB & vol arb 3 CB & vol arb 4 Fixed income arb 4 Fixed income arb 5 Event-driven 3 Global macro 3 L/S equity 8 Equity/event cluster L/S equity 1 L/S equity 2 L/S equity 3 L/S equity 4 L/S equity 5 L/S equity 6 L/S equity 7 Event-driven 1 Event-driven 2 Event-driven 4 Event-driven 5 Global macro 1 Macro/credit cluster Global macro 2 Global macro 4 Fixed income arb 1 Fixed income arb 2 Fixed income arb 3 CTA cluster CTA 1 CTA 2 CTA 3 CTA 4

DANIEL AXMER, ASSET ALLIANCE

Daniel Axmer is a research analyst at Asset Alliance International (London). Asset Alliance is an investment management firm specialising in alternative investments including hedge funds and funds of hedge funds. It offers strategic opportunities for hedge fund managers, provides advisory sevices and manages investment products for HNWIs and institutional investors. Visit www.assetalliance.com
28 | HEDGE FUNDS REVIEW | October 2005

Managed account classification

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FUNDS OF HEDGE FUNDS

with the rest of the clusters. The macro/credit cluster has two global macro and three fixed income managers. The macro managers are different; one is systematic, the other discretionary. However, they are both similar in realised volatility. The main reason the fixed income managers are found in this cluster is they tend to be quite directional and either invest in emerging or global credit markets. The equity/event cluster is the largest, consistsing of all our equity and eventdriven managers except one from each category. These two styles are grouped together as they generate their returns from the same markets. In these cases, the data indicate it doesnt matter if the event-driven manager is doing merger arbitrage or special situations, they both benefit from the same market conditions. Of the four event-driven managers, two are merger arbitragefocused and two are special situations-focused. The same conclusion can be drawn from the equity managers. They are a mixture in terms of style (long bias, long/short and market-neutral) and geographically (North America, Europe, Asia and global), but still part of the same group possibly due to the correlation between equity markets. In the CB/mixed cluster, the CB and volatility arbitrage managers cluster together before connecting with any other manager. However, this cluster does link up with a variety of other managers. There are a couple of reasons for this. The two fixed income arbitrage managers are mortgage-backed securities (MBS) managers and, therefore, their performance has more in common with this cluster than the other fixed income managers, given the optionality and less directionality of MBS managers. The equity manager here is short-bias. The macro manager follows a mix of discretionary and systematic and appears much less directional compared to its peers. It is quite surprising to find the event-driven manager in this cluster. However, it might have a bit less exposure to the underlying market compared to its peers. It is apparent from the output that for this portfolio these equity long/short and event-driven managers must be considered simultaneously in terms of allocation and diversification decisions. Also, some fixed income managers have more in common with macro managers than their fixed income peers. Decisions on fixed income allocation should therefore be broken up into split assessments. Both CTAs and CB and volatility arbitrage managers appear quite homogenous. From the cluster analysis, we can calculate the risk/return characteristics for each cluster, done by equally weighting each managers returns. The CTA cluster, for example, is calculated by allocating 25% to each manager in the cluster. We can see from the table above, CB/ mixed and equity/event have the lowest returns, and macro/credit and CTA the highest. On a risk-adjusted basis, CB/mixed and macro/ credit have the highest ranking. Cluster analysis has divided our managers into four distinct groups with different risk/return profiles. By allocating to the different clusters, we

Annualised return CB/mixed Equity/ event cluster Macro/ credit cluster CTA cluster 6.56% 6.14%

Annualised volatility 2.41% 3.48%

Minimum return -1.47% -2.34%

Maximum return 2.32% 2.46%

Sharpe ratio (Rf=3%) 1.48 0.90

Maximum drawdown -1.90% -2.79%

12.73% 11.01% CB/mixed cluster

6.14% 15.65% Equity/ event cluster 27.22% 0.00% 0.00%

-3.83% -7.60% Macro/ credit cluster 1.15% 40.52% 78.81%

3.76% 9.76% CTA cluster 0.00% 3.96% 11.05%

1.58 0.51 Annualised return 6.56% 9.35% 12.22%

-6.53% -17.89% Annualised volatility 2.14% 3.09% 5.14%

Low-risk portfolio Mediumrisk portfolio High-risk portfolio

71.63% 55.51% 10.14%

should increase the level of diversification in our portfolio and we can now evaluate the diversification benefits of the different clusters by using mean variance optimisation.

MEAN VARIANCE OPTIMISATION

Mean-variance analysis is one of the most commonly used tools in portfolio construction. There are many problems with mean-variance optimisation, but by using the clusters we effectively reduce estimation errors and produce more robust results compared to optimisation on a manager level. Since cluster analysis is backward-looking and mean-variance optimisation is forward-looking, we must assume the managers are expected to exhibit similar risk/return characteristics in the future. The graph below shows the efficient frontier derived from the four clusters, that is, the portfolio combinations with the highest return given the level of risk. The minimum variance portfolio consists of 72% in CB/mixed, 27% in equity/event and 1% in macro/credit. Moving up the frontier, the equity/event allocation quickly gets substituted for macro/credit allocation, which has a higher return and Sharpe ratio. It is also interesting that, though the CTA cluster has the worst risk-adjusted return properties, it is present throughout most of the frontier portfolios, weighted between 1% and 11%. The frontiers average Sharpe ratio is 1.9, highlighting benefits of diversifying over the different clusters. Except for the top-corner portfolio, all others are invested in at least three clusters. The lower table shows the statistics of three frontier portfolios with different risk characteristics. In summary, the point of starting with cluster groups is that the results are more stable and robust than if we performed the optimisation on the individual managers returns.

By first aggregating the managers into groups using cluster analysis, we make sure that managers that perform differently are not put in to the same group and vice versa. Combining this information with the risk/return objective for our overall portfolio, we can then formulate the asset allocation framework that seeks to optimise our risk-adjusted returns. This analysis demonstrates that cluster analysis can be useful in many parts of the portfoliomanagement process. It can easily be implemented in the manager/ strategy classification procedure and in the portfolio-construction process. Combining cluster analysis with portfolio theory can serve as the starting point when it comes to the strategy allocations. When running a cluster analysis, it is important to do it on a rolling monthly basis and over different time periods to evaluate the consistency of the results. A manager may change clusters for different reasons like change in strategy, leverage, gross/net exposure, underlying market conditions, and so forth. Cluster analysis, like any other tool, should not be used in isolation but rather as a tool to enhance the existing investment process.

EFFICIENT FRONTIER USING 4 CLUSTERS

14 13 12 11 10 Return (%) 9 8 7 6 5 4 1 2 3 4 Risk (%) 5 6 7

REFERENCES
Baird, J.C. and Noma, E. (1978). Fundamentals of Scaling and Psychophysics, chapter 11, New York: John Wiley & Sons, Inc. Bares, P.-A., R. Gibson and S. Gyger (2001). Style Consistency and Survival Probability in the Hedge Funds Industry. Working Paper, Swiss Federal Institute of Technology Lausanne, EPFL and University of Zurich. De Souza, C. and Gokcan, S. (2004). Allocation Methodologies and Customizing Hedge Fund Multi-Manager Multi-Strategy Products. Journal of Alternative Investments, Spring 2004: 7 21 Kaufman, L. and Rousseeuw, P.J. (1990). Finding Groups in Data: An Introduction to Cluster Analysis. New York: John Wiley & Sons, Inc. Lhabitant, F-S. (2004). Hedge Funds: Quantitative Insights. New York: John Wiley & Sons, Inc. Insights.
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KEY POINTS
Fund of funds managers are increasingly using cluster analysis to monitor overlap in their target funds risk and return. Analysis using cluster analysis should produce results that are more robust and stable than those from optimisation on individual managers.
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