Asset Allocation with Hedge Funds on the Menu

Hedge funds have become an increasingly important asset class in recent years. This paper discusses the asset allocation decision of an investor who is considering investing in hedge funds. We develop a simple procedure that may help in making this decision when the assets consist of a core equity portfolio, the risk-free asset, and a hedge fund. A regime-switching framework is used to model the joint returns of the hedge fund and the equity market. We use monthly intervals so that the regimes can change only at most once a month. Within each regime the returns on the two risky assets are bivariate lognormal with constant parameters. These parameters are estimated from the empirical data. We show how to determine the optimal allocation of an investor, such as a pension plan, to hedge fund assets. Our procedure is based on the maximization of expected utility, and we use different horizons. We restrict the admissible strategies to buy-andhold strategies, so we do not allow for portfolio balancing. We illustrate the procedure with examples. We find that bias in the hedge fund expected return has an important impact on the results. We note that some hedge fund strategies have substantial left-tail risk to which investors may be very averse. This type of risk aversion is not adequately captured by the standard expected utility model, but it could be added as a constraint.