Evaluating Gains from Diversifying into Hedge Funds Using Dynamic Investment Strategies

Abstract

In this study, we examine the returns and investment policies for portfolios of stocks and bonds with and without hedge funds. We apply the discrete-time dynamic investment model that allows for all moments of the return distribution to affect the analysis. This is of importance given that earlier studies have documented that hedge fund returns tend to be non-normally distributed. Our principal findings are (1) the gains from adding hedge funds to portfolios of stocks and bonds are statistically significant for most of the strategies investigated, (2) hedge funds enter the risk neutral portfolio as well as the most risk-averse portfolio, and (3) allocations to hedge funds are extensive at times.