for this is that we are effectively substituting an asset with low volatility (the hedge fund portfolio) for one with higher volatility (the equity portfolio or the total portfolio). In addition, the hedge fund portfolio is not perfectly correlated with the equity portfolio. Both of these effects mean that substituting into the hedge fund portfolio reduces total portfolio volatility. Clearly, if the hedge fund portfolio is riskier or more highly correlated with equity market returns, then total portfolio volatility will not be reduced by as much, or even at all, when we substitute into hedge funds. Suppose, though, that an investor wanted to add hedge funds to the portfolio, but didn't want a change in total portfolio risk. Since the hedge fund portfolio (Portfolio B) in our hypothetical example has a bondlike volatility, the investor might substitute hedge funds for fixed income. For example, in Figure 26.3 allocations to hedge funds funded through reductions in fixed income leave the total portfolio volatility more or less unchanged. Again, this result depends on the structure of the hedge fund portfolio and our assumptions on hedge funds volatility and correlation. If the hedge fund portfolio is skewed toward higher-volatility strategies or strategies that are more highly correlated with equity markets (e.g., equity long/short), then total portfolio volatility will increase if the hedge fund allocation is funded out of fixed income. The analysis of the impact on total portfolio volatility is important to investors for two reasons. First, it reinforces the point that investors should analyze the characteristics of their hedge fund portfolios prior to investing. The second reason Figure 26.3 is important is because it provides investors with an easy decision rule: How they fund the hedge fund allocation depends in part on how much risk they would like to take in the overall portfolio. In addition to analyzing the impact on total portfolio volatility, investors should consider the impact of each funding alternative on the marginal contribution to total portfolio risk. Figure 26.4 illustrates this point by showing the mar- 0% 5% 10% 15% 20% 25% Allocation to Hedge Funds Funded from Equities -■- Funded from Bonds -sfc- Funded Pro Rata FIGURE 2G.4 Hedge Fund Contribution to Risk 14.0% -12.0% -