investors are considering strategic allocations to hedge funds. Investors are interested in hedge funds for two reasons. First, they believe that hedge funds offer the opportunity to increase expected portfolio returns. Second, investors believe that hedge funds diversify total portfolio risk. In short, hedge funds are attractive to investors because they believe that hedge funds offer the potential to increase expected portfolio return at the expense of little or no change in expected portfolio risk. While most investors would agree that hedge funds are attractive because of their potential to enhance risk-adjusted performance, they would also agree that allocations to hedge funds are difficult to analyze, largely because of the general lack of consistent data. Consequently, investors are faced with a dilemma: Because they believe that hedge fund managers can produce excess returns by exploiting informational inefficiencies, they believe that their portfolios should have hedge fund allocations. However, hedge fund allocations are difficult to analyze, in part because the same informational inefficiencies translate into inconsistent time series data. This chapter expands on our equilibrium approach to strategic asset allocation and gives investors an intuitive framework that they can use to evaluate the role of hedge funds. As we've discussed in Chapter 9, standard portfolio advice is usually based on mean-variance analysis. Typically, an analyst uses historical time series data to estimate the expected return, volatility, and correlation of returns for various asset classes. Portfolio weights are then found by using these parameters in an optimizer. However, practitioners have had reservations about fully embracing this approach. As shown in Chapter 9, optimal portfolio weights are incredibly sensitive to small changes in expected return assumptions. Chapter 9 shows further that historical average returns provide poor predictors of expected future performance. The strength of these reservations is intensified for hedge funds, due in part to the generally poor relative quality of hedge fund data.