Fixed-Income Portfolio Allocation Including Hedge Fund Strategies: A Copula Opinion Pooling Approach

Abstract

This paper adapts Meucci's [2006a, 2006b] copula opinion pooling (COP) framework to examine whether fixed income hedge fund strategies enhance the risk-return spectrum of traditional bond portfolios. In contrast to the Black-Litterman setup, the COP approach does not rely on linear dependencies, and avoids the problems associated with the assumption of normally distributed asset returns. We analyze three scenarios that represent investor expectations about the performance of fixed income portfolios, and we add fixed income hedge fund strategies such as fixed income arbitrage, convertible bond arbitrage, and distressed securities, given expected shortfall constraints. Our results suggest that investor market expectations and attitudes toward potential losses are both important in determining the relative weight of hedge funds in the optimal portfolio. Depending on the model parameters, the allocation to hedge funds can vary greatly, from 0% to 85%.

TOPICS: Fixed-income portfolio management, portfolio theory, simulations