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Fund-of-funds construction by statistical multiple testing methods

  • Michael Wolf
  • Dan Wunderli

Fund-of-funds (FoF) managers face the task of selecting a (relatively) small number of hedge funds from a large universe of candidate funds. We analyse whether such a selection can be successfully achieved by looking at the track records of the available funds alone, using advanced statistical techniques. In particular, at a given point in time, we determine which funds significantly outperform a given benchmark while, crucially, accouting for the fact that a large number of funds are examined at the same time. This is achieved by employing so-called multiple testing methods. Then, the equal-weighted or the global minimum variance portfolio of the outperforming funds is held for one year, after which the selection process is repeated. When backtesting this strategy on two particular hedge fund universes, we find that the resulting FoF portfolios have attractive return properties compared to the 1/N portfolio (that is, simply equal-weighting all the available funds) but also when compared to two investable hedge fund indices.

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Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 445.

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Date of creation: Sep 2009
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Handle: RePEc:zur:iewwpx:445
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  1. Joseph P. Romano & Michael Wolf, 2005. "Stepwise Multiple Testing as Formalized Data Snooping," Econometrica, Econometric Society, vol. 73(4), pages 1237-1282, 07.
  2. Romano, Joseph P. & Shaikh, Azeem M. & Wolf, Michael, 2008. "Formalized Data Snooping Based On Generalized Error Rates," Econometric Theory, Cambridge University Press, vol. 24(02), pages 404-447, April.
  3. Olivier Ledoit & Michael Wolf, 2001. "Improved estimation of the covariance matrix of stock returns with an application to portofolio selection," Economics Working Papers 586, Department of Economics and Business, Universitat Pompeu Fabra.
  4. Ledoit, Oliver & Wolf, Michael, 2008. "Robust performance hypothesis testing with the Sharpe ratio," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 850-859, December.
  5. Andrews, Donald W K, 1991. "Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation," Econometrica, Econometric Society, vol. 59(3), pages 817-58, May.
  6. Donald W.K. Andrews & Christopher J. Monahan, 1990. "An Improved Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimator," Cowles Foundation Discussion Papers 942, Cowles Foundation for Research in Economics, Yale University.
  7. Jobson, J D & Korkie, Bob M, 1981. "Performance Hypothesis Testing with the Sharpe and Treynor Measures," Journal of Finance, American Finance Association, vol. 36(4), pages 889-908, September.
  8. Kosowski, Robert & Naik, Narayan Y. & Teo, Melvyn, 2007. "Do hedge funds deliver alpha? A Bayesian and bootstrap analysis," Journal of Financial Economics, Elsevier, vol. 84(1), pages 229-264, April.
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