“…Their approach addresses the potential multicollinearity between the factors by a democratic factor orthogonalization that identifies the underlying uncorrelated components of common factors. In comparison to the traditional sequential approach (Fama and French 1993;Bessler and Opfer 2003;Opfer 2004), this procedure is not sensitive to the order in which factors are selected for orthogonalization. Hence, it eliminates the impact of the choice of the starting vector and the orthogonalization sequence.…”
This paper analyzes the contribution of hedge funds to optimal asset allocations between 1993 and 2010. The preferences of specific institutional investors are captured by implementing a Bayesian asset allocation framework that incorporates heterogeneous expectations regarding hedge fund alpha. Mean-variance spanning tests are used to infer the ability of hedge funds to significantly enhance the mean-variance efficient frontier. Further, a novel democratic variance decomposition procedure sheds light on the dynamics in the co-movement of hedge fund returns with a set of common benchmark assets. The empirical findings indicate that portfolio benefits of hedge funds are time-varying and strongly depend on investor optimism regarding hedge funds' ability to generate alpha. In general, allocations to hedge funds improve the global minimum variance portfolio even after controlling for short-selling restrictions and minimum diversification constraints. However, due to dynamics underlying the composition of the aggregate hedge fund universe, the factor structure of hedge fund returns has become more similar to the benchmark assets over time.
“…Their approach addresses the potential multicollinearity between the factors by a democratic factor orthogonalization that identifies the underlying uncorrelated components of common factors. In comparison to the traditional sequential approach (Fama and French 1993;Bessler and Opfer 2003;Opfer 2004), this procedure is not sensitive to the order in which factors are selected for orthogonalization. Hence, it eliminates the impact of the choice of the starting vector and the orthogonalization sequence.…”
This paper analyzes the contribution of hedge funds to optimal asset allocations between 1993 and 2010. The preferences of specific institutional investors are captured by implementing a Bayesian asset allocation framework that incorporates heterogeneous expectations regarding hedge fund alpha. Mean-variance spanning tests are used to infer the ability of hedge funds to significantly enhance the mean-variance efficient frontier. Further, a novel democratic variance decomposition procedure sheds light on the dynamics in the co-movement of hedge fund returns with a set of common benchmark assets. The empirical findings indicate that portfolio benefits of hedge funds are time-varying and strongly depend on investor optimism regarding hedge funds' ability to generate alpha. In general, allocations to hedge funds improve the global minimum variance portfolio even after controlling for short-selling restrictions and minimum diversification constraints. However, due to dynamics underlying the composition of the aggregate hedge fund universe, the factor structure of hedge fund returns has become more similar to the benchmark assets over time.
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