Hedge Funds and Their Strategies : An Investigation about Correlation Market Neutrality and the Improvement of Portfolio Performance

Reading the daily financial news, it becomes quite obvious that hedge funds are receiving huge attention by financial analysts and politicians. Many people fear the influence of hedge funds on single companies as well as on the global economy. This study does not judge the behavior of hedge funds. Instead, it focuses on the nature of hedge funds and their mystique image. Especially the common view of their market neutral performance is of interest, which is theoretically achieved through the use of derivatives and short positions. In this thesis the feature of market neutrality is investigated in depth, since it can improve the overall performance of investors’ portfolios in bull as well as in bear markets through diversification effects. Therefore the hedge funds and their environment, the capital markets, are examined from an academically point of view by emphasizing on the following research questions: 1. Are hedge funds performing market neutral in bull and bear markets? 2. To what extent should they be included in optimal risky portfolios according to Modern Portfolio Theory and advanced performance measurement tools, considering their degree of market neutrality? This study is based on extensive knowledge of financial and econometric theories. Capital market theories, modern portfolio theory, hedge fund data and econometric knowledge about time series analysis build the basis for further investigations and are necessary to understand the characteristics of hedge funds and hedge fund data. In order to be able to deal with the shortcomings of hedge fund data, an analytical framework for the preparation of data is created that enables the authors to start with the analysis of these questions. The framework is applicable to all kinds of hedge funds presented in this thesis and enables the reader to test further hedge fund classes by himself. In a quantitative study the created framework is applied to 2160 hedge funds of Barclays Hedge Fund Database, which builds the basis for analyzing market neutrality. Further input for the portfolio optimization consists of 19 hedge fund indices, which were provided by the Greenwich Alternative Investment Hedge Fund Database and 4 benchmark indices for the stock and bond market. The analysis consists of two different parts. For the first research question various correlation and return matrices are constructed, which shall provide information about market neutrality of hedge funds. A correlation matrix also serves as important input for the portfolio analysis and therefore builds the basis for the analysis of the second research question. This shall provide some fundamental recommendations about the weighting of diverse hedge fund classes in optimal risky portfolios. The conducted analysis demonstrated clearly the following findings: 1. Market neutrality has to be rejected for most hedge fund strategies. It is only attainable through strategies, which focus more on arbitrage and/or the bond market and therefore seems to be more a by-product than an actually provoked feature. 2. Only two strategies, equity short and convertible arbitrage, managed to beat the benchmark and to improve the overall performance of the portfolio when taking the specific return distribution of hedge funds into account