than two. However, it is important to remember that a positive and significant historical performance does not constitute a prediction that those same managers will be able to add value in the future.4 How does our analysis help us evaluate the implied hurdle rates? In our opinion, investors can draw three principal inferences. First, the fact that the historical adjusted performance for each hedge fund sector substantially exceeds the implied hurdle rates suggests that the hurdle rates have been achievable, particularly for modest allocations. Second, the fact that there is some variation across strategies in the significance of the historical adjusted performance suggests to us that investors are advised to carefully consider how to develop, monitor, and maintain their hedge fund portfolios. Finally, the variation in significance in historical performance across managers within each hedge fund sector seems to us to imply that investors will need to be quite careful in how they select specific hedge fund managers. CONCLUSION Many institutional investors are perplexed by the challenges associated with investing in hedge funds. Paradoxically, the characteristics of the asset class that make it an attractive investment also confound careful analysis. In this chapter, we have shown that our equilibrium framework can be extended in a way that gives investors the ability to make reasoned allocations to hedge funds. In common with the overall theme of this book, our framework relies on the principles of applied portfolio theory. Since hedge fund returns are more difficult to estimate than hedge fund volatility and correlation, our portfolio advice relies instead on hedge fund risk characteristics. In addition, our portfolio advice relies on an investor's existing portfolio as a neutral reference point. Thus, our approach gives investors a framework for deciding how much incremental return they must receive on hedge funds relative to the other assets in the portfolio to justify a particular allocation. We view these returns as implied hurdle rates for hedge fund allocations. Applying our framework to a stylized version of a typical U.S. institutional investor's portfolio, we conclude that the implied hurdle rates for hedge fund allocations are quite small. Indeed, the implied hurdle rates for modest allocations to hedge fund portfolios diversified across strategies are in the range of 100 to 125 basis points over cash. Our analysis of specific hedge fund managers is indicative that at least historically, investors could have constructed portfolios to achieve or even 4In the presence of sufficient data, it is often useful to stratify the data into favorable and unfavorable equity market periods and separately calculate the beta in each of these scenarios. If a hedge fund portfolio becomes more (positively) correlated with equity markets in difficult environments, the implied equilibrium hurdle rate of return for that manager should increase as well.