Creating a Fund of Funds (FoFs) is predominantly being done on a bottom-up basis with top-down overlay conducted on the strategy level. The FoFs investment team usually formulate an outlook on the different strategies that they cover and from this make allocations to the hedge funds/strategies that are considered to best reflect their outlook. The portfolio construction is fine tuned by a discretionary call on the level of comfort of having different target weights for the different strategies, for example 35% in Equity Long/ Short, 15% in Event Driven, etc. In most cases FoFs have limits in terms of how much they can allocate to a specific strategy (as well as single manager).
An important aspect that is often forgotten in the portfolio construction process is that a lot of different strategies may be driven by also highlights which managers affect which factors and to what extent. In addition, PCA can be indicative of the underlying diversification of a portfolio. Implicitly, it would be desirable for a portfolio's returns to be driven by several drivers that are uncorrelated to each other as opposed to only one or two that are responsible for the bulk of the performance. The FoF manager can also gain insight into whether there are any underlying bets/tilts in the portfolio that are sub-optimal. This article goes through how PCA can be utilised in FoFs management to increase the knowledge of how the underlying funds interact. Emphasis is placed on the interpretation of PCA and less so on the underlying calculations.
PCA is a quantitative method used to simplify and find linear combinations in groups of data. The objective is to reduce the number.
The obstacles with PCA are that components are not directly observable and there may not even exist a real variable that reflects
the component. One approach to identify the components is to run a correlation analysis against variables that are thought to influence the underlying data. Obviously it is important.
The returns are collected net of fees and covers the five-year period starting in January 2000 and ending in December 2004. Funds with managed account track records shorter than five years are backfilled using the performance of the manager's flagship fund, which the managed account is replicating. When selecting the managers, emphasis has been placed on selecting as diverse a portfolio as possible with managers within each strategy pursuing different sub-strategies. For example, the Long/Short Equity segment consists of managers with long bias, short bias, variable bias, market neutral/pair trading, and statistical arbitrage.