Optimal Portfolio Allocations with Hedge Funds∗

This paper analyzes optimal investment decisions, in the presence of non-redundant hedge funds, for investors with constant relative risk aversion. Factor regression models with optionlike risk factors and no-arbitrage principles are used to identify and estimate the market price of hedge fund risk, the volatility coefficients of hedge fund returns and the correlation between hedge fund and market returns. Timing ability causes stochastic fluctuations in these return characteristics. Outside investors optimally hold hedge funds for diversification purposes and are motivated to hedge fluctuations in return components caused by timing ability. The paper examines the portfolio structure and behavior and the impact of timing and selection abilities. Incorporating hedge fund classes in asset allocation strategies is shown to yield significant economic gains.