Funds of Hedge Funds Take the Wrong Risks

Abstract

On average the fund of hedge funds industry over the last 15 years has delivered alpha with a high information ratio. Unfortunately, these alphas come with significant common-factor exposures for which the typical fund was unrewarded. While funds of hedge funds can deliver a valuable product, sloppy manager selection and portfolio construction typically result in less-than-pure alpha generation. A naive selection of a fund of hedge funds may thus lead to assuming relatively expensive common-factor exposure without necessarily accessing significant skill-based returns. A multifactor modeling of fund of hedge fund returns can help to identify skillful value-added.