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Dynamic hedge fund portfolio construction

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Abstract

In this paper, we provide further evidence on the use of multivariate conditional volatility models in hedge fund risk measurement and portfolio allocation, using monthly hedge fund index return data for the period 1990 to 2009. Building on Giamouridis and Vrontos (2007), we consider a broad set of multivariate GARCH models as well as the simpler exponentially weighted moving average (EWMA) estimator of RiskMetrics (1996). We find that while multivariate GARCH models provide some improvement in portfolio performance over static models, they are generally dominated by the EWMA model. In particular, in addition to providing better risk-adjusted performance, the EWMA model leads to dynamic allocation strategies that have substantially lower turnover and could therefore be expected to involve lower transaction costs. Moreover, we show that these results are robust across low-volatility and high-volatility sub-periods.

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