The value added of hedge fund styles in multi‐asset portfolios

Abstract

PurposeAcademic research has shown that diversification today may not only include stocks and bonds but also alternative investments like hedge funds. However, practical and effective methods to identify the hedge fund styles that really enhance the risk return characteristics of a traditional portfolio as well as optimal allocation sizes are not available. The aim of the paper is to try to close this gap by proposing a portfolio optimization approach based upon the traditional market exposures of the different hedge fund strategies.Design/methodology/approachFor this purpose, the paper first measures the bull and bear market betas of the main hedge fund strategies (equity market neutral, event driven, global macro, relative value, and managed futures). Based on the strategy characteristics, the authors then develop a systematic framework that calculates what percentage of each basic asset should be substituted for by hedge fund strategies to achieve the maximum results. The paper uses hedge fund index data from Hedge Fund Research and Barclay Hedge for the January 1999‐April 2011 sample period.FindingsThe empirical results show that this approach leads to an improvement in the annualized return of the optimized portfolio.Originality/valueThe paper adds to the existing literature by showing that it is possible to substitute traditional assets with hedge fund indices based on their exposures (beta) in varying market environments as a way to optimize the overall portfolio.