Paper abstract: For 5,500 North American hedge funds following 11 different strategies, we analyse the stand-alone performance of these strategies using a stochastic discount factor approach. Employing the same data, we then consider the diversification benefits of each hedge fund strategy when combined with a portfolio of US equities and bonds. We compute the out-of-sample Black-Litterman portfolios, with Bayes-Stein, higher moments and simulations as robustness checks. All but two hedge fund strategies out-perform the market as stand-alone investments; and all but one provide significant diversification benefits. The higher is an investor’s risk aversion, the more beneficial is diversification into hedge funds.

Dr Emmanouil Platanakis joined the University of Bath School of Management in October 2017 as an Assistant Professor of Finance. His research focuses on estimation risk management, portfolio management and evaluation, portfolio theory, optimal asset allocation under parameter ambiguity and higher moments, asset-liability management and modelling, alternative investments, hedge funds, cryptocurrencies and pension finance.

Professor David Newton is Head of Division for Accountancy, Finance and Law at the School of Management.