Abstract

We report systematic, out-of-sample evidence on the benefits to an already well diversified investor that may derive from further diversification into various hedge fund strategies. We investigate dynamic strategic asset allocation decisions that take into account investors’ preferences as well as return predictability. Our results suggest that not all hedge fund strategies benefit a long-term investor who is already well diversified across stocks, government and corporate bonds, and REITs. Only strategies whose payoffs are highly nonlinear (e.g., fixed income relative value and convertible arbitrage), and therefore not easily replicable, constitute viable options. Most of the realized economic value fails to result from a mean-variance type of improvement but comes instead from an improvement in realized higher-moment properties of optimal portfolios. Medium to highly risk-averse investors benefit the most from this alternative asset class.

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