Using hedge funds to enhance asset allocation in life cycle pension funds

Abstract

Life cycle investment funds are one of the fastest growing segments in the defined contribution pension industry. Despite concerns over long-term investment performance, many life cycle products continue to remain focused on traditional core allocations to US stocks and US bonds, with very little exposure to alternative asset classes such as commodities or global real estate. This paper outlines a methodology for assessing the potential enhancement to long-term performance that may arise from the inclusion of hedge funds into life cycle investment products. The results indicate a potential role for hedge funds. It is argued that exposure can be most efficiently gained via investable hedge fund of fund indices or by using widely available technology to replicate hedge fund returns via common risk factors. Because the approach developed in this paper can be easily modified, it could prove useful to financial planners, investors, portfolio managers and policy makers in assessing the risk and return characteristics of various life cycle asset allocation strategies. © 2009 Palgrave Macmillan 1478-5315.