Optimal Allocation to Hedge Funds: An Empirical Analysis

Jaksa Cvitanic, Ali Lazrak, Lionel Martellini, Fernando Zapatero: What percentage of their portfolio should investors allocate to hedge funds?

Author(s):

Jaksa Cvitanic

University of Southern California

Ali Lazrak

University of British Columbia

Lionel Martellini

Marshall School of Business, University of Southern CaliforniaEDHEC Business School

Fernando Zapatero

Marshall School of Business, University of Southern California

The only available answers to the above question are set in a static mean-variance framework, with no explicit accounting for uncertainty on the active manager’s ability to generate abnormal return, and usually generate unreasonably high allocations to hedge funds. In this paper, we apply the model introduced in Cvitanic, Lazrak, Martellini and Zapatero (2002b) for optimal investment strategies in the presence of uncertain abnormal returns to a database of hedge funds. We find that the presence of model risk significantly decreases an investor’s optimal allocation to hedge funds. Another finding of this paper is that low beta hedge funds may serve as natural substitutes for a significant portion of an investor's risk-free asset holdings.

Type: Working paper
Date: le 01/01/2003
Research Cluster : Finance

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