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Holdings analysis shows investors how funds of funds produce returns. An increasing number of investors and fund-of-fund managers have turned to style analysis in recent years as a way of gaining insight into hedge funds and hedge funds of funds. Properly done, style analysis gives more detailed information than the usual returns-based analysis.At present, there are at least two types of style analysis: holdings or asset based and returns based. Except for cost and, in some cases, lack of data, there is no logical reason to use only one of these techniques. Each one provides its own insights.
Several hedge fund data vendors offer style analysis tools and reports. Alternatively, if you have access to the necessary raw data, a knowledge of statistics and the ability to program, you can build your own system.By the way, holdings-based analysis is rarely called style analysis. But it is clearly an attempt to do almost the same thing. A holdings-based analysis of a fund of funds divides the fundís holdings, or constituent hedge funds, into groups and analyzes the behavior of the groups. Many funds of fundsí marketing material present a pie chart that shows a breakdown of their funds holdings, which is part of the information the investor needs.
The pie chart almost invariably has the breakdown for the date of the report, which, of course, is all but useless for understanding the behavior of the fund.A reasonable report would show the fundís average holdings for the period of interest, say, one year. It would then show the returns and risks for that year for the hedge funds the fund of funds held.Ideally, the risks and returns should be graphed, labeled and color-coded the same as the pie chart. Finally, the report should somehow show the correlations between the hedge funds held.
Tables are all but useless here. If a fund of funds contains 10 investment styles, then those styles have 45 pair wise correlations, which is way too many to make sense of. There are about a half a dozen ways of showing this information graphically, none of them very good, but all more revealing than listing the data in a table.
A few minutesí perusal of these three charts should reveal why the fund-of-funds manager produced the results he did. In other words, the charts should show which groups produced the profits and losses and whether the manager weighted the groups fortuitously.
Unfortunately, such graphs do not use all or even most of the available information. A moderately curious investor might want to know whether the fundís returns are higher or lower than average funds of funds. More, he or she might want to know how its allocations to the various hedge fund groups differ from the average fund of funds.Did the selection add or subtract value? Did the fund of fundsí group weightings add value? Did the managerís holdings changes add or subtract value?
A style analysis report (or software) allows the investor to drill down into the results, making all of the comparisons I listed above and more. Strictly speaking, there is no reason to stop at the hedge fund group. The hedge funds in a particular fund-of-funds group, for example, could be compared to those in the benchmark.Unfortunately, funds of funds are not always willing to list the funds they invest in, so this level of detail is usually not possible.
For similar reasons, it is not always possible to analyze individual hedge funds. Part of the problem is the sheer number of positions. A statistical arbitrage fund may hold thousands of positions at any one time.More important, many hedge funds are not transparent. Returns-based style analysis is one way around this problem. Iíll discuss this approach at a later date.
Notice that a style analysis tells what the hedge fund or fund-of-funds manager did. It does not tell why he did it, much less whether it was a good idea.For example, a fund-of-funds manager who has no money in short-only hedge funds might have made this decision because he does not understand how diversification works, because he has made a bet on the direction of the stock market or because he is unwilling to put money in a style that must loose money on average. Not all of these reasons have equal merit.
In a sense, a style analysis is a way of preparing for an interview with a hedge fund or fund-of-funds manager. The person being interviewed, not incidentally, may be the person giving the interview. Whether the fund-of-funds manager has money in short-only funds, to continue the example above, is not particularly important. What are important are his reasons.
An earlier version of this article appeared in MARHedge.
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