READING, U.K. (HedgeWorld.com)–Reducing the probability of returns lower than the portfolio’s mean return may be a tricky proposition when it comes to incorporating hedge funds into an overall portfolio, but it isn’t impossible, according to Harry M. Kat, associate professor of finance at the University of Reading.

Mr. Kat has done plenty of research on the risks and rewards of hedge fund portfolios, but until now has offered little in the way of ideas on how to battle the lower returns hedge funds exhibit during times of stock market downturns.

In his latest study, “Taking the Sting Out of Hedge Funds,” Mr. Kat proposes that investors in hedge funds could lessen the blow of negative hedge fund performance by investing a small amount in stock index puts and, in turn, by accepting a drop in expected return that is unlikely to exceed 1% per annum, depending on the hedge fund allocation.

Traditionally, the addition of hedge funds in a portfolio has meant an increase in a portfolio return’s distribution skewness, which means that in the distribution of returns most of them have the probability of being lower than the mean return of the investment portfolio. According to the study, long/short equity and equity market-neutral funds are hit especially hard when the equity market goes sour, which is reason for the portfolio’s lower return and skewness.

The solution to the problem may come in the form of a fourth asset class, namely out-of-the-money put options on the Standard & Poor’s 500 stock index. Mr. Kat found that even a small allocation is enough to make a difference in a portfolio. Mr. Kat based his conclusion on the return calculations of hundreds of portfolios of different allocations to stocks, bonds, hedge funds and put strategies using data from Tremont* TASS from 1994 to 2001.

It is also more inexpensive to engage in a rolling S&P 500 put option strategy than to purchase a guaranteed hedge fund. According to Mr. Kat’s research, the option strategy never costs more than 0.85% a year. This amount can be expected to remain low in the current interest rate environment and is not prohibitively high for practitioners Mr. Kat concluded. *Tremont Advisers Inc., Rye, N.Y., is a minority investor in and strategic partner with HedgeWorld.