Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions—typically banks—that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into

We explore the e#ective gain or loss in alpha from the point of view of the investor due to the volatility of a fund and its correlations to other asset classes. Fund managers and investors can be guided by this to increase the utility that is ultimately delivered to the investor. In this analysis of investor utility the Sharpe ratio is shown to be misleading and the tracking error has no role at all. A new class of funds---called "hyperpassive"---is suggested which are similar to traditional index funds, but which aim to deliver a comparable expected return with less volatility than the benchmark. It is also shown that the optimal allocation to additional asset classes can be surprisingly high when the correlations are small.

This article builds off the summary of research provided by Edwards and Gaon [2003]. The authors describe: … the structure and operation of the hedge fund industry, the various investment strategies pursued by hedge funds, [and] what we know about the returns and overall performance of hedge funds …” The authors conclude that while there is some evidence that hedge funds may be able to generate excess returns, this conclusion needs to be confirmed with more refined techniques for evaluating hedge fund performance and with better data. It would appear then that any conclusions on hedge funds are still uncomfortably tentative. With that caveat in mind, we will review both academic and practitioner research from the standpoint of a hypothetical institutional investor who is looking into whether hedge funds make sense for their portfolio. 1 Discomfort with MPT After the dramatic losses in the equity markets during the past three years, there has been a struggle to understand how hedge funds, with their promise of absolute returns, might

University of Lausanne. The authors thank Prof. Francois-Serge Lhabitant, who was their advisor on this thesis and

What percentage of their portfolio should investors allocate to alternative investment vehicles? The only available answers to the above question are set in a static meanvariance framework, with no explicit accounting for uncertainty on the active manager’s ability to generate abnormal return. In this paper we consider the problem of an investor who can choose between the riskfree security and two risky securities: a passive fund that tracks the market and a hedge fund. The hedge fund might o¤er a positive abnormal expected return or alpha (excess risk-adjusted expected return). The investor has power utility and is uncertain about both the expected return of the index and the alpha of the hedge fund, but upgrades beliefs in a Bayesian way. We derive analytic expressions for the optimal investment policy of the investor and calibrate our model to a database of hedge funds. Our results have important implications for investors who consider including alternative investment vehicles in their portfolios. In particular, they suggest that low beta hedge funds may serve as natural substitutes for a signi…cant portion of an investor risk-free asset holdings.