Hedge-Fund Risk Budgeting

Richard Horwitz, Jesse Horwitz

From the early years of the 21st century in the US, the average endowment has increased its exposure to alternative assets (including hedge funds) from 8% to 44% and the largest ones have increased it from 20% to 60%.¹¹NACUBO-Commonfund Study of Endowments. During the same period the average state pension fund has increased its exposure to alternative investments from 9% to 23%.²²Wilshire Report on State Retirement Systems: Funding Levels and Asset Allocation. Hedge funds have become a material percentage of the overall risk of institutional investors.

This chapter will present the unique challenges in hedge-fund risk budgeting. It will explain structural (beta) and idiosyncratic (alpha) risk behaviour. The chapter will address the persistence of both risk and return in hedge funds. It will address both “CIO”³³CIO here stands for complex, illiquid and opaque securities and the initialism is a play on “chief investment officer”. See “CIO risk” later in the chapter. and dynamic risk. It will also address diversification, the key to achieving risk-efficient portfolio constructions.

ALPHA AND BETA RISK

Hedge funds are absolute-return strategies⁴⁴Investment strategies that seek