Optimum diversification in hedge fund allocations Author: François-Serge Lhabitant Source: Hedge Funds Review | 13 Jun 2012
Hedge fund investors are returning to the concept of modern portfolio theory: diversification by combining several hedge funds with different return distributions and risk profiles to diversify risk.
Harry Markowitz’s 1952 seminal paper on modern portfolio theory contains the foundation of what seems to be the only free lunch in finance: the reduction of risk through portfolio diversification. An investor who spreads wealth among many imperfectly correlated assets will observe a decrease in the volatility of their portfolio, says Markowitz. When properly executed, there is no reduction in average return and so, apparently, no bill for the lunch.
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