TY - JOUR T1 - Hedging and Constructing Portfolios of Active Strategies: <em>Strategy Time Horizon and Estimation Errors</em> JF - The Journal of Alternative Investments SP - 39 LP - 47 DO - 10.3905/jai.2018.21.1.039 VL - 21 IS - 1 AU - Alexander Rudin AU - William M. Marr Y1 - 2018/06/30 UR - https://pm-research.com/content/21/1/39.abstract N2 - Many essential portfolio management tasks incorporate the development of views on future correlation between assets. To the extent that such views are formed by analyzing historical data, they are associated with estimation errors. The authors discuss estimation errors for active strategies and describe how such errors affect hedging and portfolio construction decisions. They point out that for active strategies with time horizons extending over multiple data points within the historical sample, the number of independent observations is not provided by the number of data points in such a sample, but is considerably smaller instead. That leads to a situation where the correlation estimation error scales down with the sample size much more slowly than it does over the square root of the sample size—the rate that traditional thinking suggests. A t-statistic reflecting this intuition is offered for a single strategy hedging problem. The authors also consider a new “litmus test,” which could help determine whether or not a correlation matrix across multiple active strategies can be effectively estimated from historical data. Implications for hedging and construction of hedge fund and risk premia portfolios are discussed briefly as well.TOPICS: Portfolio construction, statistical methods, risk management ER -