Boost your traditional portfolio: Activate traditional asset classes with alternative investments

Abstract

We propose a new methodology to include hedge funds in a traditional portfolio. The concept of substitution consists of activating a passive traditional investment strategy in a given asset class by adding active hedge fund strategies focusing on the same asset class. Our analysis, based on long-term data, shows that activated asset classes outperform the passive investments in terms of total performance, risk-adjusted performance and downside protection. Aggregating activated asset classes into an overall portfolio improves the efficiency of the initial portfolio without deteriorating its fat tail risk. Finally, we show that the substitution approach leads to similar results as an optimisation approach in which the hedge fund portfolio is optimised as a stand-alone investment class and then added to the traditional portfolio. These findings validate an alternative solution for institutions that want to invest in hedge fund strategies, a solution that may be closer to their approach of portfolio management. © 2011 Macmillan Publishers Ltd.