Illuminating Hedge Fund Returns to Improve Portfolio Construction

In this article the authors present an applied portfolio factor model that illuminates the risk and return drivers of broad hedge fund strategies, from the opportunity-cost perspective of a portfolio investor who owns traditional assets. The authors demonstrate how to interpret and use key information from factor attribution to improve hedge fund manager selection. They find that diversification is the primary benefit of adding select hedge funds to a portfolio of traditional assets. But differentiating managers that add true diversity from the crowd requires high selectivity, aided by the ability to disentangle returns into traditional risk premiums, alternative risk premiums, and alpha. Portfolio diversification is improved when hedge fund selection focuses on capturing alternative risk premiums and pure alpha