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Portfolio Optimization and Hedge Fund Style
Allocation Decisions
Noël Amenc and Lionel Martellini¤
March 19, 2002

This paper attempts to evaluate the out-of-sample performance of an improved estimator of the covariance structure of hedge fund index returns, focusing on its use for optimal portfolio selection. Using data from CSFB-Tremont hedge fund indices, we …nd that
ex-post volatility of minimum variance portfolios generated using implicit factor based
estimation techniques is between 1.5 and 6 times lower than that of a value-weighted
benchmark, such di¤erences being both economically and statistically signi…cant. This
strongly indicates that optimal inclusion of hedge funds in an investor portfolio can potentially generate a dramatic decrease in the portfolio volatility on an out-of-sample basis.
Di¤erences in mean returns, on the other hand, are not statistically signi…cant, suggesting that the improvement in terms of risk control does not necessarily come at the cost
of lower expected returns.

Noël Amenc is with the EDHEC Graduate School of Business and Misys Asset Management Systems.
Lionel Martellini is with the Marshall School of Business at the University of Southern California. Research
for this paper received the support of the EDHEC/MISYS multi-style/multi-class program. Please send all
correspondence to Lionel Martellini, University of Southern California, Marshall School of Business, Business
and Economics, Ho¤man Hall 710, Los Angeles, CA 90089-1427. Phone: (213) 740 5796. Email address:
martelli@usc.edu. We would like to express our gratitude to Vikas Agarwal, Hossein Kazemi, François-Serge
Lhabitant, Terry Marsh, George Martin, and Narayan Naik for very useful comments and suggestions. We
also thank Jérôme Maman and Mathieu Vaissié for superb computer assistance. All errors are, of course, the
authors’ sole responsibility.