asking what the portfolio weights should be on the basis of specific expected return assumptions, we instead ask what return can justify a specific allocation. The benefit of this approach to investors is that we rely on our ability to estimate volatility and correlation from time series data rather than attempting to estimate expected returns. As discussed in Chapters 9 and 16, volatility and correlation are more easily estimated from historical data than expected returns. We call the returns required to justify a specific hedge fund allocation the implied "hurdle rates." We find the hurdle rates by making specific reference to the other holdings in an investor's portfolio. Hurdle rates can be viewed as setting the minimum expected return that an investor should require for a particular hedge fund allocation. They are useful because they can give investors a yardstick by which a specific hedge fund portfolio should be judged. Our principal finding is that the implied hurdle rates for hedge fund portfolios can be quite low, especially for modest allocations. Moreover, our historical analysis suggests that some hedge fund portfolios have been able to achieve these hurdle rates. As a result, our principal recommendation is that investors should include hedge funds as part of their strategic asset allocations. The remainder of this chapter is organized as follows. The next section discusses why we believe hedge funds can add value. We then address the issue of available hedge fund data. In the next two sections, we show how our equilibrium framework can be used to analyze hedge fund allocations. Implementation of the hedge fund program is covered in the subsequent sections, followed by concluding comments. POTENTIAL ADVANTAGES OF HEDGE FUNDS TO INVESTORS Why are hedge funds attractive to investors? At one level, this is an easy question to answer: A suitably constructed portfolio of hedge funds can be attractive because it has the potential to generate positive returns for the overall portfolio. However, in judging hedge fund performance we must ask the question "Attractive relative to what?" Posing the question in this way forces us to explicitly consider the underlying economics of hedge funds relative to other investment choices. Since views on equity and fixed income markets are ultimately expressed through long and short positions in public securities markets, one natural comparison for hedge fund portfolios is the active risk taken by traditional active managers. We can reframe the question to ask what structural factors give hedge fund managers the capability to generate value relative to traditional active managers. In particular, we want to compare the risk and performance characteristics of hedge fund managers relative to cash with the risk and performance characteristics of traditional active managers relative to an index of publicly traded securities. Why does it make sense to compare a hedge fund manager to a traditional active manager? After all, traditional active managers usually hold long positions in the securities in their portfolios and are measured versus an index, while hedge fund managers usually take long and short positions and are measured relative to cash. How can the two be compared? Let's look at the return of the traditional active manager a little more closely,