Table 26.2 illustrates this point with two potential portfolios. The first portfolio, labeled Portfolio A, has equal weight assigned to each of four hedge fund sectors: relative value, event driven, equity long/short, and tactical trading. (The relative value sector is itself a blend of three strategies: equity market neutral, fixed income arbitrage, and convertible arbitrage.) The overall volatility of this portfolio is 6.1 percent. However, although equal investments are made in each sector, Table 26.2 also shows that each sector does not contribute equally to hedge fund portfolio volatility. In fact, in this example the equity long/short sector at the margin contributes about half of the risk in the hedge fund portfolio.

Although some investors would be comfortable with a disproportionate amount of risk allocated to just one strategy, many would not. In fact, analysis of the level of diversification in the portfolio provides a useful way to think about structuring the portfolio. Rather than beginning with portfolio weights and then calculating the risk decomposition, let's instead begin with a target of equal risk contributions and work backwards to find the corresponding portfolio weights.

The results of this exercise are shown in Portfolio B. We see that the portfolio weights can change significantly when we make diversification across strategies our goal. For example, the equally weighted portfolio has 25 percent of the portfolio value and 47 percent of the portfolio risk at the margin in equity long/short, while the equal risk weight portfolio has 25 percent of the portfolio volatility (at the margin) in equity long/short and only 14 percent of the portfolio value.

The portfolios in Table 26.2 are clearly two among many, and are meant to illustrate the following point: Investors should be careful to allocate risk to those hedge fund strategies that they think will offer the best opportunities to enhance risk-adjusted performance. For example, an investor with no specific information about the relative merits of one hedge fund sector versus another might be inclined to pick portfolio weights so that each hedge fund sector had an equal contribution to risk (e.g., Portfolio B). However, if an investor believed that one particular sector was likely to do better than another, then risk in the hedge fund portfolio should be shifted into the sector with the higher return expectations.

IMPLEMENTING THE HEDGE FUND ALLOCATIONS

There are two ways (at least!) that investors can implement their hedge fund allocations. The first is to make an outright allocation to hedge funds in the same way

TABLE 2G.2 Equal Value Weight and Equal Risk Weight Portfolios

Portfolio A Portfolio B Contribution Contribution Allocation to Risk Allocation to Risk

Relative value 25% 12% 39% 25%

Event driven 25 24 22 25

Equity long/short 25 47 14 25

Tactical trading 25 17 26 25

Portfolio volatility 6.1% 5.2%