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Alternative Investments - June 21, 2006

First anniversary of the EDHEC Hedge Fund Diversifier Benchmarks

To mark the first anniversary of the EDHEC Hedge Fund Diversifier Benchmarks, the EDHEC Risk and Asset Management Research Centre and Lyxor Finance jointly organised a breakfast seminar at Le Meurice hotel in Paris on 8th June to present the year’s results.

Noël Amenc, PhD, Director of Research at EDHEC Business School and Director of the EDHEC Risk and Asset Management Research Centre, gave a presentation entitled "EDHEC Hedge Fund Diversifier Benchmarks: Concept and Results" to an audience of French institutional investors.

Professor Amenc initially explained that while hedge funds are certainly not risk-free investments that deliver constant positive returns, their performance and diversification qualities make them an essential asset class in portfolio allocation. The differing risk exposures of hedge funds - both market risk and alternative risks (volatility, liquidity, credit, etc.) - are their principal source of performance.

For Professor Amenc, an institutional investor has two good reasons to invest in hedge funds:

  1. Access to active management: since hedge funds do not have to submit to the constraints of traditional management, and benefit from considerable investment freedom and flexibility, they can maximise their potential for alpha

  2. Due to the quality of their betas, hedge funds contribute not only their decorrelation capacity (reduction in volatility) but also their ability to reduce extreme risks (co-kurtosis, co-skewness)

EDHEC have designed two benchmarks that optimise the diversification qualities of hedge funds when combined with traditional asset classes: the EDHEC Hedge Fund Equity Diversifier and the EDHEC Hedge Fund Bond Diversifier. These benchmarks result from optimal selection and allocation of the hedge fund strategies represented by the EDHEC Investable Hedge Fund Indices in order to diversify equities or bonds.

The EDHEC diversification benchmarks were designed on the basis of a simple observation: since the strategies are not exposed to the same betas, they don't have the same diversification qualities. For example, the long/short styles have a beta profile that is fairly similar to that of long-only indices and can be considered more as substitutes than as diversifiers. The diversification benefits have to be evaluated not only in terms of reduction in volatility (correlation), but also in terms of improvement in positive skewness (co-skewness) or reduction in extreme risks (co-kurtosis).

After one year of existence, the results of the EDHEC diversification benchmarks show that due to their choice of strategies and their allocation process, they are significantly more effective than funds of hedge funds (as proxied by the non-investable EDHEC Fund of Funds index). The comparative reductions in volatility and Value at Risk hold up geographically (Europe and the US) and across styles (value, growth, small cap, large cap).