Efficient Hedge Fund Strategy Allocations – Systematic Framework for Investors that Incorporates Higher Moments

In this paper, we provide a realistic framework that investors can use to optimize hedge fund portfolio strategy allocations. Our approach includes important aspects that investors need to address in the real world, such as how limited resources can restrict the ability to conduct multiple due diligences. Additionally, our approach is not based on a utility function, but on an easily quantifiable preference parameter, lambda. We need to account for higher moments of the return distribution within our optimization and approximate a best‐fit distribution. Thus we replace the empirical return distributions, which are often skewed or exhibit excess kurtosis, with two normal distributions. We then use the estimated return distributions in the strategy optimization. Our dataset comes from the Lipper TASS Hedge Fund Database and covers the June 1996‐December 2008 time period. Our results show in‐ and out‐of‐sample that our framework yields superior results to the Markowitz framework. It is also better able to manage regime switches, which tend to occur frequently during crises. Lastly, to test our results for stability, we use robustness tests, which allow for the time‐varying correlation structures of the strategies.