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Many studies focus on the benefits of adding a specific alternative investment (e.g., see Black [2006] on volatility, Akey [2005] on commodities, Amin and Kat [2003] on hedge funds) to a passive portfolio invested in traditional assets. The authors study the relative merits of six alternative investments-volatility, commodities, investable hedge fund indices (IHF),1 funds of hedge funds (FoHF), single-manager hedge funds (HF), and private equity (PE)-as additions to the main traditional asset classes-bonds, equities, and real estate (RE)-for an institutional investor with an investment horizon of at least one year. The authors examine the effects of three types of expected return forecasts: a "Historical" scenario based on recent performance of all asset classes, a "Naïve Subjective" scenario where performance of alternative investments is kept at recent historical levels while performance of traditional assets is set at market equilibrium levels, and a range of "Least Discriminatory Subjective" scenarios where the naive subjective view is combined with the market equilibrium view according to a least discrimination method that is more general than the Black-Litterman method but in the same spirit.
There is extensive research (Amene and Martinelli [2002], Gueyie and Amvella [2006]) on the role of hedge funds in traditional portfolios. Several institutional investors recently allocated resources to HFs, while others rejected the idea or approved of investments in PE instead.2 The authors broaden the discussion by investigating the relative merits of three types of hedge fund investments (FoHF, IHF, and HF) in a wider context than presented in previous research. There is also significant research to suggest that, like hedge funds, commodities and volatility provide diversification from equities and bonds. The authors also recognize recent unprecedented interest from investors in commodities3 and volatility (Hafner and Wallmeier [2006]). Finally, the surge in assets under the management of PE firms,4 although perhaps cyclical, suggests including PE as well in this study.
The authors set out to answer three questions: 1) Should optimal passive portfolios include allocations to volatility, commodities, hedge funds, and PE? 2) What is the most attractive path to an investment in hedge funds? 3) Are the relatively new investable hedge funds merely disguised funds of hedge funds? The Historical scenario suggests much larger allocations to commodities and HF and much smaller allocations to equities...