Broad market risk for sector fund of funds: A copula-based dependence approach

A crucial problem for institutional money managers that are focussed on one sector or sub-sector of financial markets is to know to what degree they depend on the broad markets they aim at diversifying away from. This is a special problem for fund of fund (FoF) managers because with an increasing number of target funds, the marginal contribution from diversification decreases and active bets of target funds may be cancelled out. Furthermore, when appropriate tools to hedge or reduce risks are unavailable for the respective sectors, investments in derivatives on a more general universe or index may become necessary. Both problems make an appropriate method for estimating sector FoF risk exposure to the general markets necessary. We provide a solution for sector portfolios that is especially comforting when being applied to small datasets. Our parsimonious approach of using only short time spans for estimating broad market dependence of the sector portfolio is particularly interesting for practical applications, as it is in line with requirements in the industry where very recent and frequently updated risk measures are used and demanded for by regulators.