Strategic Hedge Fund Portfolio Construction that Incorporates Higher Moments

In this paper we optimize a hedge fund portfolio considering higher moments of the different hedge fund strategy return distributions. We replace the empirical return distributions which are often skewed or exhibit excess-kurtosis with two normal distributions to approximate a best-fit distribution. This procedure is known as the mixture of normal method and is widely used in financial applications. We then use the estimated return distributions in the strategy optimization. Further we incorporate that institutional investors and in particular fund of hedge fund managers seek an optimal allocation of resources and therefore only execute a limited number of due diligence processes. Furthermore real investor's preferences are con-sidered in optimization procedure. In order to test our results for stability we use robustness tests which allow for the time-varying correlation structures of the strategies.