  The proprietary nature of Hedge Fund investing means that it is common
practise for managers to release minimal information about their returns. The
construction of a Fund of Hedge Funds portfolio requires a correlation matrix
which often has to be estimated using a relatively small sample of monthly
returns data which induces noise. In this paper random matrix theory (RMT) is
applied to a cross-correlation matrix C, constructed using hedge fund returns
data. The analysis reveals a number of eigenvalues that deviate from the
spectrum suggested by RMT. The components of the deviating eigenvectors are
found to correspond to distinct groups of strategies that are applied by hedge
fund managers. The Inverse Participation ratio is used to quantify the number
of components that participate in each eigenvector. Finally, the correlation
matrix is cleaned by separating the noisy part from the non-noisy part of C.
This technique is found to greatly reduce the difference between the predicted
and realised risk of a portfolio, leading to an improved risk profile for a
fund of hedge funds.
