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The Journal of Portfolio Management

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Article

A Style-Based Market Risk Model for Hedge Fund Portfolios

Xuelong Zhou, Adam Litke and Michael Mclaughlin
The Journal of Portfolio Management Summer 2010, 36 (4) 124-131; DOI: https://doi.org/10.3905/jpm.2010.36.4.124
Xuelong Zhou
is a market risk manager and a director at Securities and Investments Group, Wells Fargo Securities in New York, NY.
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  • For correspondence: jasonxzhou@gmail.com
Adam Litke
is a managing director and the head of market risk management at Securities and Investments Group, Wells Fargo Securities in New York, NY.
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  • For correspondence: adam.litke@wachovia.com
Michael Mclaughlin
is a market risk manager and a director at Securities and Investments Group, Wells Fargo Securities in New York, NY.
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  • For correspondence: michael.mclaughlin@wachovia.com
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Abstract

In this article, the authors develop a market risk model for hedge fund portfolios by integrating cluster analysis, extreme value theory (EVT), and copula modeling. Because the cluster model is exclusively based on fund returns, cluster classifications are more objective than self-reported styles. The EVT contribution considers the fat-tailed distribution of hedge fund returns, implicitly accounting for jump risk. The copula method accounts for the dependence between clusters. Two Gumbel copulas are constructed—one on the average returns of funds in the clusters, and the other on returns of all funds in the clusters. The first copula is directly applicable to a highly diversified portfolio and the authors show how to apply this copula to a general hedge fund portfolio. The second copula is suitable for simulations on nondiversified portfolios and also provides a tool for stress tests. Monte Carlo simulations indicate that investing in a broadly diversified hedge fund portfolio is not riskier than investing in a traditional diversified portfolio.

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The Journal of Portfolio Management: 36 (4)
The Journal of Portfolio Management
Vol. 36, Issue 4
Summer 2010
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A Style-Based Market Risk Model for Hedge Fund Portfolios
Xuelong Zhou, Adam Litke, Michael Mclaughlin
The Journal of Portfolio Management Jul 2010, 36 (4) 124-131; DOI: 10.3905/jpm.2010.36.4.124

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A Style-Based Market Risk Model for Hedge Fund Portfolios
Xuelong Zhou, Adam Litke, Michael Mclaughlin
The Journal of Portfolio Management Jul 2010, 36 (4) 124-131; DOI: 10.3905/jpm.2010.36.4.124
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  • Article
    • Abstract
    • DATA DESCRIPTION
    • CLUSTER ANALYSIS
    • JOINT DISTRIBUTIONS OF CLUSTER RETURNS
    • RISK SIMULATION ON HEDGE FUND PORTFOLIOS
    • SUMMARY
    • ENDNOTES
    • REFERENCES
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