Who Should Buy Hedge Funds?: The Effects of Including Hedge Funds in Portfolios of Stocks and Bonds

Abstract: Using monthly return data on 455 hedge funds over the period 1994-2001 we study the diversification effects from introducing hedge funds into a traditional portfolio of stocks and bonds. Our results indicate that although the inclusion of hedge funds may significantly improve a portfolio's mean-variance characteristics, it can also be expected to lead to significantly lower skewness as well as higher kurtosis. This means that the case for hedge funds includes a definite trade-off between profit and loss potential and suggests that, contrary to popular belief, hedge funds might be more suitable for institutional than for private investors. Our results also emphasize the fact that to have at least some impact on the overall portfolio, one has to make an allocation to hedge funds which exceeds the typical 1-3% that many institutions are currently considering.