Adding alternative assets: return enhancement, diversification or hedging?

Adding assets (so-called extensions) to an already existing portfolio is a reoccurring question in times of rapidly expanding investment opportunity sets. Examples for this “how much” question are the incorporation of liquid alternative assets in the form of hedge funds or alternative risk premia in a global balanced portfolio, the addition of global equities to a domestic equity portfolios or simply the optimal allocation of corporate credit within a government debt portfolio. While this is hardly a new question and a variety of tools have already been established, we suggest a new framework to decompose the demand for risky assets in economically meaningful components. This allows us to identify whether a particular allocation is driven by demand created from noisy return estimates or by more predictable hedging and diversification demand.