Funded from Bonds ,.,..,^..,..,... Funded Pro Rata FIGURE 26.5 Implied Hedge Fund Hurdle Rates some senses, then, it is reasonable for an investor to ask whether a particular implementation of a hedge fund program can achieve these hurdle rates. EVALUATING IMPLIED HURDLE RATES How can we use the implied hurdle rates? Our implied hurdle rates correspond to the minimum return required to invest at a particular level in a hedge fund portfolio with specific risk characteristics. In our example, the risk characteristics are those of the portfolio with an equal contribution to risk from each hedge fund strategy. The risk characteristics of the hedge fund strategies, in turn, were developed from time series of hedge fund indexes. At one level, we might think about making passive investments to each of the hedge fund strategies by investing in the indexes. However, this choice is not available to us-we cannot implement a hedge fund allocation by passively investing in a hedge fund index. Thus, an investor can reasonably ask whether a portfolio of particular hedge funds can be constructed whose historical volatility and correlation resemble the characteristics of the indexes, and whose historical performance at least matches the implied hurdle rates. A simple way to approach these issues is to begin with an evaluation of the risk characteristics and then analyze the historical performance. Our purpose in evaluating historical volatility is to determine whether it is feasible to construct a portfolio of hedge funds for each strategy whose volatility matches that of the hedge index for that strategy. Our analysis of historical volatility focused on manager-specific returns in the following hedge fund strategies-event driven, equity long/short, convertible arbitrage, equity market neutral, fixed income arbitrage, and tactical trading (convertible arbitrage, equity market neutral, and fixed income arbitrage are the subsectors of the relative value sector). Table 26.3 shows the number of managers in each hedge fund sector and the data source. Although our database covered manager returns from January 1994 through May 2001, we chose to reduce the number of