funds are substituted for exposure to other asset classes. Alternatively, investors can treat the hedge fund portfolio as a substitute for other active strategies (e.g. active U.S. large-cap equity or active U.S. fixed income). Suppose an investor wanted to substitute a hedge fund portfolio for a traditional active manager, say an active U.S. large-cap equity manager. If the hedge fund manager equitizes a portion of the cash (e.g., by purchasing futures contracts), and invests the rest in the specific hedge fund portfolio, the investor now has a portfolio that can be compared with a traditional active manager. This strategy is called a "portable alpha" strategy. For our purposes, we'll assume that investors are substituting away from equity and fixed income and into hedge funds. The basic principles that are described in this case can be easily applied to analyze portable alpha strategies. Let's look at the case where an investor decides to make outright allocations to hedge funds. In this case, the investor must consider the volatility of a hedge fund portfolio and its correlation with other asset classes. For discussion purposes, we'll assume that the hedge fund portfolio is the equal risk portfolio discussed earlier (i.e., Portfolio B). This portfolio has a volatility of 5.2 percent and a correlation with U.S. equity of 0.51. An investor who chooses to make an outright allocation to hedge funds must also choose how to fund the allocation. That is, the investor must choose which asset class (or combination of asset classes) the hedge fund program substitutes for in the overall portfolio. In our simple example, there are three natural alternatives: (1) the investor can scale all other assets down proportionately; (2) the investor can substitute away from equity holdings and into the hedge fund portfolio; (3) the investor can substitute away from bonds and into hedge funds. The impact on total portfolio volatility of each funding alternative is summarized in Figure 26.3. The chart plots alternative allocations to hedge funds and the resulting portfolio volatility for each of the three funding methods. What happens when we substitute out of equity and into hedge funds? In our 0% 5% 10% 15% 20% 25% Allocation to Hedge Funds Funded from Equities -■- Funded from Bonds & Funded Pro Rata FIGURE 26.3 Portfolio Volatility and Hedge Fund Allocations 10.5% -10.0% -