Asymmetric Returns and Optimal Hedge Fund Portfolios

Abstract

It is well known that various hedge fund strategies exhibit negative skew and excess kurtosis–the asymmetric return problem. Ignoring asymmetry may have detrimental consequences on performance periodically such as larger than expected negative returns. In this article, the author examines the hedge fund strategy allocation problem from the portfolio manager's viewpoint, focusing on various optimization approaches that offer potential solutions. The key conclusion is that optimization methods that explicitly address asymmetry produce very different strategy allocations from those that do not. Specifically, the author finds that asymmetric optimization techniques tend to prefer more positively skewed and low kurtosis hedge fund strategies such as market neutral, equity sector, rotational, and systematic macro in lieu of strategies such as distressed debt.