This study addresses the optimal asset allocation problem for investors managing a diversified portfolio of stocks, bonds, and hedge funds. Significant allocations to hedge funds may be justified due to their diversification benefits, even when hedge funds generate minimal or no alpha. For instance, an investor with constant relative risk aversion and concern for inter-temporal utility should allocate around 20% to hedge funds, even under the assumption of zero alpha. Historical correlations and specified alpha levels indicate that equity and event-driven hedge fund strategies offer the greatest diversification advantages, while global macro and managed futures strategies are less favorable. However, optimal hedge fund allocations are highly sensitive to alpha assumptions. If alphas fall below -1%, the allocation to hedge funds typically approaches zero, whereas an alpha above 2% can lead the investor to allocate nearly 100% to hedge funds. This sensitivity also applies to individual hedge fund strategies. Finally, given that investing in many different hedge funds can be cost-prohibitive, we assess the allocation impact of investing in a limited number of hedge funds instead of a broad, uninvestable index. We find that reducing the number of funds held—from 30 to 5—substantially increases the likelihood that hedge funds will diminish investor utility.

We study hedge fund liquidity management in the presence of liquidity risks on the asset and liability sides. We formulate a two-period model where a single fund has always access to a liquid asset and can invest in an illiquid asset which pays off only at the end of period two. Funding liquidity risk takes the form of a random outflow originating from clients in period one. The fund suffers from a random haircut on the illiquid asset’s secondary market to cover its outflow. We solve the allocation problem of the fund and find its optimal allocation between liquid and illiquid assets. We show that the liquidation probability and the portfolio composition of the fund are revealing about the market liquidity and funding liquidity, respectively. Gates, as a device that limits the outflows experienced by the fund, helps it reduce its liquidation risk and harvest liquidity premia.