- 10% - 0% - U.S. Equity Int'l Equity Fixed Income FIGURE 2G.2 Portfolio Risk Decomposition we will represent as exposure to MSCI non-U.S. Developed Equity. Finally, the fixed income allocation is about 35 percent, which we will assume is held in U.S. investment-grade bonds. Note that even though the example is from a U.S. investor's perspective, the approach generalizes to other currency perspectives. By combining the portfolio weights of Figure 26.1 with a covariance matrix of asset returns, we can calculate the overall portfolio volatility as 9.6 percent. There are two natural questions we would like to answer about the portfolio allocations in Figure 26.1. First, we would like to know how the overall volatility of 9.6 percent is distributed across the various asset classes. Second, we would like to understand the impact on portfolio risk and return of allocating a portion of the portfolio away from each of the asset classes and into hedge funds. Figure 26.2 shows the risk decomposition corresponding to the allocations of Figure 26.1. These figures show us how much of the portfolio's volatility, at the margin, can be attributed to each of the asset classes. Effectively, they show us how we are "spending" or "budgeting" our overall portfolio volatility of 9.6 percent. It is not too surprising that at the margin, almost 61 percent of the volatility is attributable to U.S. equity, given the portfolio's high equity allocation. The risk decomposition in Figure 26.2 is important, as it serves as a reference point for any portfolio reallocations: We want to know how the distribution of risk changes as we allocate portions of the portfolio to hedge funds. DEVELOPING A HEDGE FUND ALLOCATION Although some investors will make allocations to specific hedge funds, many more will instead make broad allocations to the asset class. Since the term "hedge funds" covers many alternative strategies, it is reasonable to first identify a potential hedge fund portfolio structure and then assess the volatility of this structure and its correlation with other asset classes. Ideally, the hedge fund portfolio would be structured so that the allocation of risk across hedge fund strategies would be consistent with an investor's views about expected returns.