How Hedge Funds Fit

Abstract

Hedge funds fit in an institutional investor's portfolio only if one can evaluate how the inclusion of hedge fund strategies would improve the performance of the entire portfolio, after considering both beta and alpha characteristics. This is more challenging than it first appears because of the opaqueness and the complexity of most hedge fund strategies. The key is to identify institutional-quality hedge funds that permit a clear understanding of the normal portfolio and provide confidence in projecting a positive, pure alpha. If these conditions can be satisfied, there are two possible approaches to incorporating institutional-quality hedge funds: 1) hedge funds as an active overlay at the total portfolio level, or 2) hedge funds as portable alpha within a traditional asset class.