Fund Uniqueness
Fund uniqueness measures (SDI and FUI) assess diversification and replicability of investments, aiding portfolio diversification and liquidity management.
7 min read | Jan 12, 2022
How Unique Is My Investment?
When making an investment decision, it is important to assess the attractiveness of a potential investment not only on its own, but also in relation to the existing portfolio. The ideal investment offers an attractive risk-return profile that stands out from all existing investments. This provides optimal diversification and should reduce the overall risk of the portfolio while increasing its profitability.
Uniqueness not only plays a key role in evaluating a potential new investment, but is also a valuable tool in managing existing investments in a hedge fund portfolio. Given the recent tendency of some hedge fund managers to worsen their liquidity terms, measuring the uniqueness of such a position relative to the rest of the portfolio makes it easier to judge whether to accept those terms or to focus attention on other positions in the portfolio.
How Can We Measure Uniqueness?
While an investment may be unique from a qualitative perspective, we focus below on two quantifiable measures of uniqueness. Both measures are based on the historical track records of all funds in the portfolio, so that a unique fund provides diversification benefits, while a non-unique fund could be replaced by other funds in the portfolio. The first measure follows the basic idea of Sun, Wang, Zheng (2009) who propose to measure strategy distinctiveness based on the correlation of a fund with the entire fund universe. Following this idea, we define the strategy distinctiveness index (SDI) as follows:
\\[SDI^i = corr\left(r^i_t, \mu^i_t \right) \\]
Where \\(r^i_t\\) is the return of a hedge fund \\(i\\) and \\(\mu^i_t\\) is the equally weighted average return of all funds in the portfolio except fund \\(i\\). Thus \\(SDI^i\\) is bounded between 0 and 2. The larger the value, the better the diversification potential when that fund is added to the portfolio. SDI thus provides a holistic measure to assess how valuable the investment strategy of a particular fund is in terms of diversification benefits compared to the average fund in the portfolio. It is thus determined not only by the uniqueness of the investment strategy, but also by how many other funds in the portfolio follow a similar strategy. To further assess whether a fund in the portfolio can be replaced by a combination of other funds in the portfolio, we define the fund uniqueness index (FUI) as:
\\[FIU^i = 1 - R^{i^2}\\]
Here \\(R^{i^2}\\) is the coefficient of determination obtained by a LASSO regression of the returns of fund \\(i\\) on all the returns of the other funds in the portfolio. \\(FUI^i\\) is thus limited to a value between 0 and 1. The larger the value, the less replicable that fund is by other existing investments in the portfolio. Although SDI and FUI should generally give similar results, there may be cases where they point in different directions. Consider a very large portfolio with many different hedge funds. Within the portfolio, there are two funds that are very different from the other investments, but very similar to each other. In this case, SDI will classify each of the two funds as unique, while FUI will indicate a low degree of uniqueness because one fund can be replicated by the other.
How Do Uniqueness Measures Perform In Real Life?
The table below shows the uniqueness of the funds in an artificial paper portfolio:
| Funds | Start Date | SDI | FUI | Most Similar Funds in the Portfolio |
|---|---|---|---|---|
| Convergence Fund 1 | 09/30/19 | 0.7032 | 0.9148 | Convergence Fund 6 & Convergence Fund 4 |
| Convergence Fund 2 | 06/30/18 | 0.7448 | 0.6163 | Convergence Fund 6 & Convergence Fund 4 |
| Convergence Fund 3 | 02/29/16 | 0.5840 | 0.5256 | Convergence Fund 6 & Divergence Fund 6 |
| Convergence Fund 4 | 02/29/16 | 0.6014 | 0.5107 | Convergence Fund 6 & Convergence Fund 5 |
| Convergence Fund 5 | 02/29/16 | 0.4321 | 0.4781 | Convergence Fund 6 & Convergence Fund 4 |
| Convergence Fund 6 | 02/29/16 | 0.3060 | 0.4037 | Convergence Fund 7 & Convergence Fund 5 |
| Convergence Fund 7 | 02/29/16 | 0.2562 | 0.3307 | Convergence Fund 9 & Long-Biased Fund 3 |
| Convergence Fund 8 | 02/29/16 | 0.5375 | 0.3265 | Long-Biased Fund 5 & Long-Biased Fund 7 |
| Convergence Fund 9 | 02/29/16 | 0.3588 | 0.2944 | Convergence Fund 10 & Convergence Fund 11 |
| Convergence Fund 10 | 02/29/16 | 0.4239 | 0.2822 | Convergence Fund 9 & Convergence Fund 11 |
| Convergence Fund 11 | 02/29/16 | 0.4309 | 0.2212 | Convergence Fund 9 & Convergence Fund 10 |
| Divergence Fund 1 | 02/29/16 | 0.5529 | 0.8242 | Divergence Fund 9 & Divergence Fund 10 |
| Divergence Fund 2 | 02/29/16 | 0.5745 | 0.6832 | Convergence Fund 5 & Convergence Fund 6 |
| Divergence Fund 3 | 02/29/16 | 0.6141 | 0.6341 | Long-Biased Fund 5 & Long-Biased Fund 7 |
| Divergence Fund 4 | 02/29/16 | 0.7316 | 0.6151 | Divergence Fund 9 & Divergence Fund 3 |
| Divergence Fund 5 | 09/30/20 | 0.3858 | 0.5960 | Convergence Fund 6 & Convergence Fund 4 |
| Divergence Fund 6 | 02/29/16 | 0.5840 | 0.4626 | Convergence Fund 3 & Convergence Fund 11 |
| Divergence Fund 7 | 02/29/16 | 1.2288 | 0.3426 | Divergence Fund 8 |
| Divergence Fund 8 | 02/29/16 | 1.1163 | 0.3426 | Divergence Fund 7 |
| Divergence Fund 9 | 02/29/16 | 0.6873 | 0.3293 | Divergence Fund 4 & Divergence Fund 10 |
| Divergence Fund 10 | 02/29/16 | 0.5600 | 0.3009 | Convergence Fund 11 & Divergence Fund 9 |
| Long-Biased Fund 1 | 09/30/17 | 0.4422 | 0.6167 | Convergence Fund 6 & Convergence Fund 4 |
| Long-Biased Fund 2 | 02/29/16 | 0.6092 | 0.4971 | Long-Biased Fund 7 & Long-Biased Fund 5 |
| Long-Biased Fund 3 | 02/29/16 | 0.3531 | 0.3045 | Long-Biased Fund 6 & Long-Biased Fund 4 |
| Long-Biased Fund 4 | 02/29/16 | 0.4076 | 0.1372 | Long-Biased Fund 5 & Long-Biased Fund 6 |
| Long-Biased Fund 5 | 02/29/16 | 0.4995 | 0.1160 | Long-Biased Fund 6 & Long-Biased Fund 7 |
| Long-Biased Fund 6 | 02/29/16 | 0.4242 | 0.1137 | Long-Biased Fund 7 & Long-Biased Fund 4 |
| Long-Biased Fund 7 | 02/29/16 | 0.4209 | 0.1075 | Long-Biased Fund 6 & Long-Biased Fund 5 |
Table 1: Uniqueness of hedge funds in a paper portfolio. As of December 2021 and based on 5-year track records, if available, and otherwise based on a common time period. Table sorted by FUI. Source: Resonanz Capital
The table shows that the SDI and FUI ratings point in the same direction for most funds. However, for some funds, the FUI is significantly lower than the SDI. This is the case, for example, with Divergence Fund 7 and 8. While SDI shows the best scores, well above 1, FUI is significantly lower. Both funds are the only macro funds in the paper portfolio, so they add value in terms of diversification and have a high SDI. However, both funds follow a very similar strategy, so one fund can easily be replaced by the other if one wants to run a more concentrated portfolio or if one of the funds should be closed for additional investments. FUI will therefore generally pose a higher hurdle than SDI. In essence, SDI provides an indication of whether an (additional) strategy could be attractive to the portfolio, while FUI provides an indication of whether that specific strategy can be substituted by other existing investments.
What Did We Learn?
Assessing the uniqueness of a hedge fund relative to existing investments is important for portfolio implementation and can help, for example, with liquidity management. We introduce two new quantitative measures of uniqueness:
-
- SDI
- FUI
Both analyze the uniqueness of a fund strategy from a slightly different perspective. While SDI provides an indication of whether an (additional) strategy could be potentially attractive for the portfolio, FUI provides an indication of whether this specific strategy can be substituted by other existing strategies.