Asset Allocation and Hedge Funds," suggests a framework for evaluating an allocation to hedge funds within a broader investment portfolio. This chapter explores the management of a portfolio of hedge funds, first defining hedge funds, and then offering a framework for evaluating hedge funds and addressing portfolio construction issues. Managing a portfolio of hedge funds is similar to managing any portfolio, and involves all of the same steps. The clear difference is that the assets traded are interests in hedge funds rather than individual securities. First, the universe of investable assets needs to be defined and, if possible, classified into groups of similar assets to facilitate analysis. Second, the portfolio manager must develop views on the investment characteristics of each asset. Third, a risk budget is set and the assets are assembled into a portfolio. Finally, the assets and the portfolio are monitored on an ongoing basis to ensure that the investment characteristics continue to be consistent with the investor's goals. If we were to substitute "hedge fund" for "asset" in this brief outline, we would have summarized the process of managing a portfolio of hedge funds. As discussed in previous chapters, investment returns derive either from benchmark exposure or from alpha. In equilibrium, risks uncorrected with the market return do not earn a risk premium, so alpha cannot be earned consistently. For the most part, however, investors appear to reject this idea. Although indexing, which creates pure benchmark exposure, is increasingly popular, it is still the case that a significant proportion of investment assets are held in actively managed investments, in which the investment manager attempts to add returns in excess of benchmark returns. A lively academic debate considers whether excess returns can be consistently earned, and if so, whether they derive from anomalies, frictions, or exposures to previously unidentified risk factors. This debate is beyond the scope of the discussion here. An investment in any asset class can run along a continuum that ranges from pure indexing to pure active management. In pure indexing, the investor attempts to recreate the returns of a benchmark index either by exactly replicating index holdings or by creating a basket of securities that very closely track the benchmark index's returns. Active managers attempt to add alpha, loosely defined as returns in excess of benchmark returns, by deviating from benchmark holdings, either by reweighting benchmark securities or by holding securities not represented in the