Handbook of Hedge Funds

24

Asset Allocation and Hedge Funds

Arbitraging is like making love to a gorilla. You do not stop when you are tired. You stop when the gorilla is tired.

Rule No.2

Finally convinced of the apparent advantages of hedge funds as risk diversifiers or as absolute return generators, many investers and advisers are now contemplating their inclusion in traditional portfolios. Indeed, if there are opportunities, hedge funds should provide a better means of exploiting them, due to their greater flexibility, ability to sell short, incentive structures, use of more esoteric instruments and more nimble management than on the long-only side. But the benefits of adding a fund of hedge funds to a traditional strategic portfolio are yesterday’s news. The problem today is to reconcile the alternative and creative nature of hedge funds with the discipline required in an asset allocation process. This is a delicate task that raises several new questions. Should hedge funds be considered as a separate asset class or as a different way of managing traditional assets? What percentage should a rational investor allocate to them? How frequently should a hedge fund portfolio be rebalanced? All these issues should be clarified before any allocation is made. Unfortunately, as we will see, analysing hedge funds is not the same as analysing traditional fund managers. The option-like payoffs and unusual correlation profiles of hedge funds open new avenues in portfolio construction. Consequently, hedge funds ...