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The late 1990s brought a cascade of new investment research into the efficacy of hedge funds and their role in portfolios. When I wrote Lamm [1999], I proposed that a 100% exposure to hedge funds was optimal under certain conditions. The underlying logic was straightforward-hedge funds constituted a unique asset class that dominated stocks and bonds on a risk-adjusted basis because of market information inefficiencies.
A half-decade later, the research frontier has shifted outward, and new questions have emerged about the wisdom of making sizable allocations to hedge funds. Although hedge funds remain the best-returning asset in absolute terms or on a risk-adjusted basis, many academicians and practitioners remain skeptical. There is not only a reluctance to make significant allocations to hedge funds, but some also challenge their status as a legitimate asset class.
I revisit my original case for hedge funds and assess whether it is still applicable. I first briefly describe the myopic rationale for hedge funds, as advanced in the late 1990s, and then enumerate the key ongoing criticisms of hedge fund investing, with a response that should dispel major concerns.
I update hedge fund performance evidence, demonstrating that substantial exposure was sound advice, given the subsequent performance. As long as skepticism remains, superior hedge fund performance is not likely to be quickly arbitraged away.1
MYOPIC JUSTIFICATION FOR HEDGE FUND EXPOSURE
An examination of aggregate hedge fund returns as reported by major data providers reveals why one might easily be persuaded that hedge funds are an investor's nirvana. Exhibit 1 shows composite hedge fund returns as reported by EAI, HFR, and CSFB versus returns for stocks and bonds. The comparison begins in 1990, when fairly reliable data first became available.2
Indications are that not only have hedge funds clearly outperformed stocks and bonds over the period but they also have done so with low relative volatility and modest correlation versus stocks and bonds. This record produces attractive Sharpe ratios and demonstrates why naive retrospective portfolio optimization assigns a 100% portfolio weighting to hedge funds for most levels of portfolio risk.3
Of course, portfolio construction and optimization is in reality a forward-looking process involving expected returns and covariances. Even in this context, unless one argues that future hedge fund returns deteriorate significantly...