Pension funds only quite recently have explored alternative assets, prodded by financial crises that devastated equity returns and led to low bond returns. We assess the addition of alternative assets to pension fund portfolios in terms of the total benefit derived from diversification, addition of positive skewness, and the elimination of left tails in returns. During 1994 2012, adding portfolios of hedge funds produced significantly higher total benefits than adding real estate, commodities, foreign equities, mutual funds, funds of funds, as well as some counter cyclical and non cyclical assets. Conditioning on past total benefits improves the out of sample performance even further.

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We derive a funding liquidity measure based on synthetic borrowing in the S&P 500 derivative markets. Our measure captures funding constraints of option liquidity providers and affects importantly the returns of leveraged managed portfolios. Hedge funds with negative exposure to changes in the funding liquidity earn high returns in normal times and low returns in crises periods when funding liquidity deteriorates. The results are not driven by the existing measures of funding or market liquidity. To an extent, our funding liquidity measure also affects leveraged closed-end mutual funds and asset classes where leveraged investors are marginal investors.

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