Practical Applications of Illuminating Hedge Fund Returns to Improve Portfolio Construction

Abstract

Investors today are faced with a vast array of investment options, including hedge funds of many types. Efforts to evaluate performance relative to benchmarks, such as index composites, cannot encompass the full feature set of specific hedge funds and fall short in providing an accurate picture of risks and returns in relation to an investor’s total portfolio.

In this report, Peter Mladina , a Director of Portfolio Research at Northern Trust , explores the use of an Applied Portfolio Factor Model (PFM) to drill down into hedge fund performance. His work takes opportunity costs into consideration and highlights the importance of separating alpha from beta, assessing the risk premiums that are driving returns and evaluating the impacts on portfolio diversification and the manager selection process.