Portfolio Selection and Hedge Funds: The Effects of Autocorrelation and Tail Risk

Abstract

This paper examines the sensitivities in portfolio selection due to the effects of serial correlation in asset returns. Traditional mean-variance analysis (MVA) and mean-Conditional Value at Risk (M-CVaR) portfolio frameworks are employed on an investment universe of global stocks, world bonds and global hedge funds. The findings reveal that autocorrelation in asset returns tends to induce a downward bias in the second sample moment making hedge funds artificially desirable. This effect is found in both MVA and M-CVaR frameworks. The MVA results show that hedge funds are an attractive asset class for mean-variance investors as they lower portfolio volatility at the cost of undesirable third and fourth portfolio moments. Conversely, M-CVaR investors who prefer to minimise the left tail of portfolio returns tend to allocate little to hedge fund investments. Furthermore, M-CVaR investors with a heightened aversion to tail-risk will hold a zero portfolio weighting to hedge funds. These findings are consistent with the notion that the inherent risk in hedge funds is located in the tail of their distribution of returns.