Ultrametricity in Fund of Funds Diversification

TL;DR

This paper explores the use of ultrametricity and minimum spanning trees to analyze the similarity structure of hedge fund strategies, aiming to improve diversification and monitoring of actual versus declared strategies.

Contribution

It introduces a metric-based approach using MST to reveal hidden similarity structures among hedge funds, enhancing diversification strategies.

Findings

Ultrametricity helps identify strategy similarities.

MST reveals hidden relationships in hedge fund data.

Potential for improved fund of funds diversification.

Abstract

Minimum market transparency requirements impose Hedge Fund (HF) managers to use the statement declared strategy in practice. However each declared strategy may actually origin a multiplicity of implemented management decisions. Is then the "actual "strategy the same as the "announced" strategy? Can the actual strategy be monitored or compared to the actual strategy of HF belonging to the same "announced" class? Can the announced or actual strategy be used as a quantitative argument in the fund of funds policy? With the appropriate metric, it is possible to draw a minimum spanning tree (MST) to emphasize the similarity structure that could be hidden in raw correlation matrix of HF returns.