Alternative Investments in the Institutional Portfolio

Abstract

This study provides an update of an earlier analysis (Schneeweis and Spurgin, [1999]) of the risk and return benefits of various hedge funds and managed futures investments as stand-alone investments or as part of an investor's diversified stock/bond portfolio. Both traditional Markowitz efficient frontiers with and without investment restrictions as well as the risk and return performance of portfolios constructed from adding alternative investments to established U.S. stock and bond portfolios are evaluated. The Markowitz efficient frontier determination is conducted using alternative methods of risk and return forecasting including 1) historical returns, and 2) the construction of ex ante return forecasts in which expected returns are based on their historical return to risk relationship; that is, ex ante return forecasts are constructed from cross-sectional OLS regressions of historical return on historical variance and are used as inputs into the Markowitz portfolio optimization model. The latter approach reduces the impact of historically high (low) abnormal returns from influencing the allocation process.