Correspondence: Ryan J. Davies, Finance Division, Babson College, 224 Tomasso Hall, Babson Park, MA 02457-0310, USA. E-mail: rdavies@babson.edu

¹is Assistant Professor and Lyle Howland Term Chair in Finance at Babson College (Boston, MA). His research interests include hedge funds, mutual funds, market microstructure and European securities market regulation.

²is Professor of Risk Management and Director of the Alternative Investment Research Centre at the Sir John Cass Business School at City University in London. Before returning to academia, he was Head of Equity Derivatives Europe at Bank of America in London, Head of Derivatives Structuring and Marketing at Banc One in Tokyo and Head of Derivatives Research at MeesPierson in Amsterdam. He is a member of the editorial board of The Journal of Derivatives, The Journal of Alternative Investments and The Journal of Wealth Management.

³is an Associate at UBS (London). She is a Structurer in the Fund Derivatives Structuring team. Her research is on the detailed characterisation of hedge fund portfolio returns and optimisation within a mean-variance-skewness-kurtosis framework.

Received 19 April 2008; Revised 19 April 2008.

Abstract

This paper develops a technique for fund of hedge funds to allocate capital across different hedge fund strategies and traditional asset classes. Our adaptation of the polynomial goal programming optimisation method incorporates investor preferences for higher return moments, such as skewness and kurtosis, and provides computational advantages over rival methods. We show how optimal allocations depend on the interaction between strategies, as measured by covariance, co-skewness and co-kurtosis. We also demonstrate the importance of constructing 'like for like' representative portfolios that reflect the investment opportunities available to different-sized funds. Our empirical results reveal the importance of equity market neutral funds as volatility and kurtosis reducers and of global macro funds as portfolio skewness enhancers.