Why traditional asset allocation fails for hedge funds

Introduced in 2002 by Keating and Shadwick, Omega ratio is a relatively new addition in a hedge fund metrics library. By employing higher moments and taking into account actual shapes of distributions of returns, this measure is well-suited for hedge fund risk assessment, because of non-normality of their distributions.

 

The TAA (Tactical Asset Allocation) framework implies constructing investment portfolios based on asset classes of underlying instruments and short-term performance forecasting of the corresponding indices. Originated from the traditional asset classes, TAA is often used for hedge FoF construction. However, when applied to alternative investments, it presents a highly misleading concept:

While everyone admits that hedge fund portfolio diversification reduces manager risk, the question of the optimal number of funds in a fund of funds (multi-manager portfolios) remains commonly overlooked. The typical mistake of misusing diversification derives from the classic standpoint that more funds in the portfolio ultimately enhances its diversification. This is not so.

Hedge fund portfolio optimization drastically differs from that of conventional asset classes. Applying the common asset optimization framework to hedge funds, usually leads to highly questionable results that only mislead an inexperienced investor. The main aspects of hedge fund portfolio optimization could be outlined as follows...

As it has become clear that hedge fund indices hardly provide a strong representation of single funds, we may ask the question: Why should this matter? How could the pitfalls and drawbacks of the index methodology affect the due diligence practice? The two following points explain this problem.

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