A Portfolio Strategy with Hedge Funds and Liquid Alternatives

Volume 15, Number 4, 2017
E. William Stone and Paul J. White

The advent of liquid alternatives in mutual fund format in recent years has brought with it challenges and opportunities with regards to portfolio strategy. Interpretation of these vehicles as return enhancers or risk diversifiers can lead to very different approaches in portfolio construction. Equally indeterminate is the extent to which liquid alternatives substitute for hedge funds, that is, do liquid alternatives and hedge funds have similar risk exposures. A fundamental concern is that an investor does not overpay for exposures more cheaply accessed in liquid format as opposed to the typically more expensive limited partnership format. We present a general approach for dealing with this challenge that divides the components among beta, alternative beta (a mix of alpha and beta for liquid alternatives), and complementary beta (neither alpha nor beta for hedge funds). Our approach holds steady the amount of beta in the alternative beta portfolio (liquid alternatives portfolio), and it minimizes the amount of beta and alternative beta in the complementary beta portfolio (hedge fund portfolio). Our approach is indifferent with respect to the exact shape of the returns distribution.