Different in Nature, Common in Style: View Commonality of Single Hedge Funds and Funds of Hedge Funds

Abstract

Using style analysis, the authors show the common factor exposures of single hedge funds and funds of hedge funds (FoHFs). Despite the different nature and characteristics of the two categories, there are significant style similarities through the different business cycles. The authors argue that in general, FoHFs use substantially more leverage than single hedge fund strategies and found a positive trade-off between leverage and style exposure for the former and a negative one for the latter. Furthermore, the style in both category changes according to the business cycle, with single hedge fund strategies having more flexibility in allocation and aggressive style drifts. However, the similarities in style exposure increase in times of financial turmoil. Additionally, the exposure in equity and bond-related factors are significant and identify style drifts from the past. Finally, the authors found that both categories engage most in equity markets related factors—Betting Against Beta factors (BAB), High minus Low (HML) portfolios sorted by book-to-market to indicate value, Small minus Big (SMB) portfolios sorted by market-cap to indicate size, and Conservative minus Aggressive (CMA) portfolios.

TOPICS: Portfolio theory, portfolio construction, factor-based models, style investing

Key Findings

• • In spite of their different natures, single funds and FoHFs show striking style similarity with significant exposure to the equity markets. Their style is largely determined by dynamically shifting between long and short exposure to the factors HML, SMB, and BAB.

• • FoHFs have much stronger absolute factor exposure, which is partly determined by the large amounts of leverage used.

• • The similar style exposure spikes in times of financial stress. However, single strategies show larger advantages in exploiting business cycles, flexible factor allocation, and excess returns.