Hedge Funds in Institutional Portfolios

Abstract

Hedge funds continue to occupy a contested yet persistent role in institutional portfolios despite long-standing concerns over fees, performance, and diversification benefits. Traditional allocation frameworks evaluate hedge funds primarily through traditional metrics and benchmark-relative returns, often leading to misaligned expectations and ambiguous assessments of value. This paper argues that such approaches are incomplete and inadequate as a primary organizing principle for hedge fund allocation.

The paper reframes hedge funds as risk-transforming tools rather than a homogeneous asset class and introduces a risk budgeting framework beyond traditional metrics. Under this approach, hedge fund strategies are evaluated according to the specific portfolio risks they are intended to mitigate, reshape, or deliberately assume—such as volatility exposure, drawdown tolerance, liquidity risk, tail risk, and governance risk—rather than their behavior as measured by traditional metrics relative to traditional assets. Particular attention is given to governance-oriented and control strategies, which operate through governance as risk mitigation and are largely invisible to traditional metric-based models.

Drawing on institutional allocator practice and governance-focused investment contexts, the paper demonstrates how risk budgeting improves capital allocation coherence, strengthens fiduciary oversight, and clarifies performance evaluation. By shifting the focus from asset categories to risk intent, the framework meaningfully improves how institutions think about hedge funds and offers a more resilient approach to portfolio construction in complex investment environments.

Key Implications

• Hedge funds should be evaluated by their economic function within the total portfolio, not by strategy labels or benchmark-relative performance.
• Traditional metrics such as correlation are descriptive but insufficient for allocating and governing hedge fund risk in institutional portfolios.
• Risk budgeting reframes hedge fund allocation as an intentional allocation of risk—volatility, drawdown, liquidity, tail, or governance—rather than capital alone.
• Governance-oriented and control strategies occupy a distinct governance risk budget, where value is created through decision rights and oversight rather than market exposure.
• Making risk intent explicit improves fiduciary clarity, strengthens investment committee oversight, and reduces pro-cyclical allocation behavior.
• Risk budgeting does not replace judgment; it structures judgment by making trade-offs explicit, reviewable, and aligned with institutional objectives.

Keywords

Hedge funds; institutional portfolios; risk budgeting; traditional risk metrics; correlation; capital allocation; portfolio construction; governance as risk mitigation; alternative investments; institutional investing; risk management; investment committee governance; asset allocation frameworks

Recommended citation: Sing, C. H. (2018). Hedge funds in institutional portfolios: Risk budgeting beyond traditional metrics. Working paper.
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