An Optimization Strategy for Enhancing the Performance of Fund of Funds Portfolios

Abstract

Previous research provides evidence that much of the cross-sectional variation in equity returns can be explained by firm characteristics or sectors such as market capitalization, price-to-earnings ratios, change in operating earnings, and book-to-market ratios. One popular money management technique is to construct a portfolio (fund) using other managed portfolios (funds). The resulting overall portfolio is generally referred to as a fund of funds. This study demonstrates the potential for performance enhancement in a fund of funds when portfolio optimization techniques are employed on sector funds in order to construct the overall fund. Specifically, ex-ante optimization over sector funds that are constructed on the basis of market capitalization, price-to-earnings ratios, change in operating earnings, and book-to-market ratios demonstrates the potential for enhancing an overall equity fund performance relative to value-weighted and equal-weighted benchmark portfolios constructed from the population of stocks from which the sector portfolios are formed.

Keywords: portfolio diversification, fund of funds, performance enhancement, parameter uncertainty

JEL Classification: G11