Abstract - Optimal Portfolio Allocations with Hedge Funds

This paper analyzes optimal investment decisions, in the presence of non-redundant hedge
funds, for investors with constant relative risk aversion. Factor regression models with option-like
risk factors and no-arbitrage principles are used to identify and estimate the market price
of hedge fund risk, the volatility coefficients of hedge fund returns and the correlation between
hedge fund and market returns. Timing ability causes stochastic fluctuations in these return
characteristics. Outside investors optimally hold hedge funds for diversification purposes and
are motivated to hedge fluctuations in return components caused by timing ability. The paper
examines the portfolio structure and behavior and the impact of timing and selection abilities. Incorporating carefully selected hedge fund classes in asset allocation strategies can be a source of economic gains.

Jerome Detemple
Boston University
11.May 2010

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