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Question:

Cathy Werner, CFA, is considering adding exposure to hedge funds to her portfolio of traditional investments. Based on historical mean and standard deviation of hedge fund index returns and their correlation with traditional investment returns, Werner estimates the diversification benefits from allocating 5% of portfolio assets to hedge funds. Assuming her calculations are correct, Werner is most likely to:

A overestimate the potential diversification benefits to the portfolio.
explanation

Historical mean and standard deviation of returns for hedge fund indexes are likely to overestimate expected return and underestimate risk due to survivorship and backfill biases. As a result, determining a portfolio asset allocation to hedge funds based on these measures is likely to overestimate the diversification benefits.

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