Tremont found that by combining a 70% LIBOR weighting and a 30% S&P 500 weighting, a benchmark is created that best matches the volatility and return characteristics of a typical institutional fund of funds portfolio employing an “opportunistic” or equity-equivalent investment strategy, according to a news release.
“We found that by combining a variable absolute return component which is always going to be positive-LIBOR – mixed in with a volatility component derived from the equity markets – the S&P 500 – that we captured the key characteristics of a typical pension fund hedge fund portfolio,” said Barry Colvin, president of Tremont, in a statement. “Through our research, we determined that LIBOR was appropriate because it maintained an absolute return component. And, by adding the volatility and alpha qualities of the S&P 500, we had arrived at a benchmark that could have wide application for institutional portfolios.”
To arrive at this conclusion, Tremont created a proxy for a pension fund hedge fund portfolio, measuring volatility and returns from January 1994 to November 2002. This portfolio consisted of allocations to:
- long/short equity
- event driven
- convertible arbitrage
- equity market neutral
- fixed-income arbitrage.
Tremont compared the average returns and volatility of the hedge fund portfolio against different blends of the LIBOR/S&P 500 combination before concluding that the 70/30 mix was optimal. To determine what percentage the S&P 500 should be of the overall benchmark, an efficient frontier was plotted. It showed that, in order to match the 4% to 6% volatility target for the opportunistic hedge fund of funds portfolio, the optimal range at whichto set the S&P 500 would be between 25% and 35%. Under theseguidelines, Tremont settled on a 30% weighting.