Comparing Position-Level and Regression-Based Techniques for Isolating the “Embedded Hedge Fund” in an Active Mutual Fund
| Jul 13th, 2006 | Filed under: Performance, Analytics & Metrics, Retail Investing | By: Alpha Male |
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By: Alpha Male
Shorting out the equity market can isolate what I call the embedded hedge fund from within a long-only mutual fund. As many, including William Sharpe, have argued, you don’t need to know the actual holdings in a mutual fund to determine the amount of beta within it. One can simply regress returns against a chosen benchmark. This “top-down” process for determining market exposure has been proven by academics to have approximately the same predictive power as analyzing the actual holdings in a mutual fund to determine a hedge ratio (“Bottom-up”). However, a top-down process based on past performance alone cannot uncover an embedded hedge fund’s actual holdings. It can only determine an embedded hedge fund’s implied performance and capital requirements.
To compare the bottom-up and top-down approaches to isolating an embedded hedge fund, I shorted the TSX60 against the TD Canadian Equity Value Fund as of June 30, 2005…
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[...] So an “alpha portfolio†can be constructed by engineering-out the alpha within any active (long-only) portfolio. This is a process described in several postings on this blog back in the summer. Those of you who were on the beach, at the cottage or touring wine country around then, may be interested in this post on the topic of stripping out the “embedded market neutral hedge fund†from within what you might call the “host mutual fundâ€. [...]