Do hedge funds have their place in a Canadian institutional portfolio?

This article examines the return and risk of hedge funds (HF), and their correlations with traditional asset classes for the 1990-2002 period. Efficient frontiers resulting from optimizations with and without constraints demonstrate that it is worthwhile to include HF in a Canadian institutional investor's portfolio. HF offer a high potential return relative to risk, while weaker correlations with traditional asset classes create a beneficial diversification effect. Non-directional HF provide protection in bear markets and are more suitable for lower risk portfolios, whereas directional HF are better suited to higher risk portfolios. Caveats are necessary due to the skewness and kurtosis of the return distributions, potential biases in the return series, the lower liquidity, and the complexity of the HF industry.