How to Incorporate Hedge Funds and Active Portfolio Management into an Asset Allocation Framework

Abstract

The authors start with the observation that traditional asset allocation processes fail to integrate the two important sources of portfolio risk: systematic and active. They introduce a new approach that integrates these two risks, which offers two potentially important benefits. First, a risk allocation framework allows investors to explicitly integrate active management decisions into the overall allocation process. This leads to greater portfolio flexibility, a more accurate assessment of portfolio alternatives, and consequently improved risk/return trade-offs. Second, a risk allocation framework allows investors to more accurately assess the risks associated with individual hedge funds. This allows investors to more effectively incorporate hedge fund strategies into the overall portfolio structure.