Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Hedge Funds and Asset Allocation

The process of allocating capital to alternatives, including hedge funds, is designed to enhance portfolio returns. The process, while similar, is different for individuals and institutions. In either case, one of the primary objectives in asset allocation is to maintain or increase returns while reducing risk or volatility. The more asset classes that get added, the better the result. The less correlated the asset classes are to each other, even better. Hedge funds fit nicely into portfolios because they are both an additional asset class and have low correlation to traditional asset classes.

Investors will generally use some form of an asset allocation model. An asset allocation model is tool used by portfolio managers to allocate capital to managers in a way that maximizes return or minimizes risk, subject to portfolio constraints.

Individual versus Institutional Investors

The emergence of a theoretical framework to understand the characteristics, performance, risk, and unique properties of hedge funds, combined with the limited capacity of many of the early funds, attracted the attention of high-net-worth investors in the United States, as well as leading-edge university endowments, sophisticated family investment offices, and a small yet emerging group of leading public and private pension funds in the United States and around the world.

Initially, individual investors wanted to participate in the outsize performance relative to traditional ...