Applied Fund-of-Funds Construction: A Robust Approach

Abstract

Are academic insights effective for the real-life construction of a fund of funds, in hedge and mutual fund industries? It is typical for an academic approach to be based on ranking funds by a single quantitative measure. In practice, multiple quantitative metrics and due diligence factors are taken into account.

The mutual and hedge fund databases are fragmented, prone to a number of biases, and time-consuming to process. With thousands of funds, individual model building is impossible. The value added by overcoming those obstacles is questionable: in practice, the quantitative measures are reduced to rough “sanity checks” all the same.

We attempt to help the practitioners by proposing a simple and robust framework that provides an approximation to many ranking portfolio formation methods described in the academic literature. Contrary to the latter, the proposed approach does not require access to a vast fund database. The framework is designed for screening hedge funds, mutual funds, and individual trading strategies. A practical example is given using the data for an anonymous long-short equity hedge fund.

Keywords: Mutual fund, hedge fund, fund of funds, database, incubation bias, self-reporting, performance evaluation, portfolio formation, ranking, false discoveries, large competition, trading strategy, alpha, Sharpe ratio

JEL Classification: C10, G10, G20