Portfolios with Hedge Funds and Other Alternative Investments

We develop a flexible simulation-based optimization (SBO) method for the construction of optimal portfolios including hedge funds and other types of alternative investments. This method takes into account the skew and kurtosis of asset returns, the time series structure of asset returns, and the asymmetric nature of investor preferences for gains versus losses. Johnson (1949) translation is used to model non-normality in asset returns. Vector autoregression (VAR) methods are used to model the temporal relations among asset returns. Investor preferences are represented by the Kahneman-Tversky (1979) family of utility functions that incorporate both risk and loss aversion. Current findings are based on CSFB hedge fund indices and standard index proxies for regular asset classes. Survivorship bias is controlled for by uniform reduction in hedge fund expected returns. Preliminary results suggest that market-neutral and global macro funds have risk-return characteristics that make them attractive investment vehicles for risk and loss averse investors.