to index providers. Accordingly, the index may not be representative of what the universe of managers is actually achieving. FRAMEWORK FOR EVALUATING HEDGE FUND ALLOCATIONS How should investors think about hedge fund allocations? The very features that make hedge funds attractive (ability to transact in a large number of markets, ability to consider a wide variety of active strategies) also complicate the evaluation of a hedge fund program. In our view, since most investors already have a portfolio of assets, the most effective way to evaluate a hedge fund program is relative to those assets already held. That is, for a given portfolio of assets investors should assess the impact of a hedge fund allocation on the level and distribution of portfolio risk, then calculate the implied hurdle rate relative to cash of alternative hedge fund allocations, and finally determine whether a specific hedge fund program can achieve those hurdle rates. Why do we choose to use portfolio risk characteristics as the basis for our analysis? The reason for this relates to how much information we feel that we can reliably extract from historical time series. While estimation of expected returns, volatility, and correlation are all complicated exercises, we believe that historical time series are better suited to the estimation of volatility and correlation than expected returns. This issue becomes even more important when we consider asset classes such as hedge funds, where data availability is even more limited. U.S. Equity Int'l Equity Fixed Income FIGURE 2G.1 Hypothetical Asset Allocation To illustrate our approach, let's work through a simple example. Suppose that our current asset allocation is as shown in Figure 26.1. In many respects, this portfolio represents a stylized asset allocation of a hypothetical U.S. defined benefit program, albeit with a larger allocation to international equity than is typically seen in such plans. The asset allocation in Figure 26.1 has around 43 percent allocated to U.S. equity, which we will assume is held in a broad index such as the Russell 3000. Non-U.S. equity constitutes about 22 percent of the portfolio in Figure 26.1, which