In Search of the Optimal Fund of Hedge Funds

Abstract

In this paper, the author investigates 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. He studies 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 (2003). 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 equities and fixed income instruments such a fund can indeed be structured. The second strategy is for a fund to buy put options on itself. The author shows 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 less accurate.