Hedge Funds? Performance Measurement and Optimization Portfolios Construction

Nowadays, the hedge fund market is consistently growing and attracting more and more assets and institutional investors. As a general indicator of scale, the industry has managed around $2.5 trillion at its peak in the summer of 2008 (wilipedia.org). The alternative investment industry is growing and it is evidenced that CSFB-Tremont hedge fund index gained more than the MSCI World Index over the period January 2005 to May 2010. Due to the fact that the hedge fund market is huge and the fund returns are generally more favorable than the traditional investment instruments, such as equity and bonds, it becomes more and more important to develop a portfolio optimization method within the universe of hedge funds. In our paper, we develop four models and run the OLS regression of the fund returns with respect to different factors as specified in each model. We found that all of the four models are agree on the sign and ranking of alphas. By indicating alphas as measurement of the managers’ skill, we are able to rank hedge funds’ performance by ranking alphas. Choosing the portfolio with the highest alpha and also with the minimal variance by imposed some constrains on the weights of individual funds gives us the optimal portfolio.