TY - JOUR T1 - Taking the Sting Out of Hedge Funds JF - The Journal of Wealth Management SP - 67 LP - 76 DO - 10.3905/jwm.2003.320492 VL - 6 IS - 3 AU - Harry M. Kat Y1 - 2003/10/31 UR - https://pm-research.com/content/6/3/67.abstract N2 - Although the inclusion of hedge funds in an investment portfolio can significantly improve that portfolio's mean-variance characteristics, it can also be expected to lead to significantly lower skewness and higher kurtosis. In this article, the author shows how this highly undesirable side effect can be neutralized by allocating a fraction of wealth to out-of-the-money put options on the relevant stock index. Roughly speaking, the costs of the proposed skewness reduction strategy will be higher 1) the higher the hedge fund allocation, 2) the lower the expected equity risk premium, and 3) the higher the bond allocation relative to the equity allocation. In the current low interest rate environment, for portfolios with a more or less equal allocation to stocks and bonds, the costs of skewness reduction are unlikely to be much higher than 1% per annum. For portfolios with relatively high bond allocations, however, the costs could amount to 3% or even more. This confirms that the benefits of hedge funds heavily depend on the portfolio they are added to and that the attractive mean-variance properties of (portfolios including) hedge funds may come at a significant price. ER -