Hedge Funds Allocation: Case Study of a Swiss Institutional Investor – June 2000 Adobe PDF icon

Laurent Favre – AlternativeSoft AG & José-Antonio Galeano – Lombard Odier & Cie

Asset allocation advisers usually use the mean-variance framework to show the benefits of investing in hedge funds. They prove that this is not optimal and develop a method based on a modified Value-at-Risk model for non-normally distributed assets. They take the example of a Swiss pension fund investing part of its wealth in hedge funds. Using a shortfall risk approach they are able to show that investing in a diversified Hedge Funds portfolio is beneficial for lowering modified Value-at-Risk. Then, we analyze several hedge fund strategies using local regression analysis. We obtain the payoffs of these strategies and compare them with the payoff of a standard Swiss pension fund portfolio. Finally, we compute for a representative hedge fund the price of the option like feature of the incentive fee and the premium paid to the investor by the fund for taking liquidity risk. We find that the return risk adjusted benefits of investing in hedge funds are reduced between 19% and 41% if we take into account the liquidity premium and the survivorship bias.

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