a hedge fund portfolio are expected to be similar to the benefits of diversification within a stock portfolio. The tremendous challenge in portfolio construction again arises from short return histories commonly found for hedge funds. Hedge funds with attractive long-run return histories are often closed to new money, so hedge fund investors may find themselves putting together portfolios of managers with short return histories of varying lengths. In addition, strategies change as managers respond to market conditions, incubate new strategies, and modify their investment approaches. Once again, using judgment as well as quantitative methods is extremely important. In some cases, the greatest use of quantitative tools is as a means of checking return and risk assumptions for reasonableness. Few hedge funds are managed to a consistent level of volatility or beta. Typically, only funds based on quantitative processes target beta and standard deviation of returns, while most other managers use heuristic approaches to portfolio construction. In addition, many hedge fund managers vary portfolio risk characteristics as a part of their investment process, based on their views. Most vary total exposures, and many vary market exposure. Consequently, long-term volatility and correlation assumptions for portfolio construction purposes may be difficult to assess, and decisions based on short-term risk characteristics present the hazard of quick changes in portfolio risk. Further complicating matters is the fact that measuring risk is not straightforward for some hedge fund strategies. An example is merger arbitrage. A typical merger arbitrage trade involves purchasing shares in the target of an announced acquisition and selling short shares of the acquiring firm, in proportions consistent with the terms of the bid. For example, if the acquirer offers two shares for each share of the target, then the merger arbitrageur would purchase one share of the target and sell short two shares of the acquirer to be neutral. The spread in value between the long and short positions of this trade represents the market's assessment of the likelihood that the deal will break. The wider the spread, the more probability the market assigns to a failed bid. In fact, the major risk of a merger is that the deal breaks, and the spread on the neutral position above widens. This risk is not captured in typical equity risk models, and is not necessarily symmetrically distributed. Suppose that the spread is 6 percent, and the spread may widen to 20 percent if the deal breaks. The arbitrageur can earn the 6 percent spread or can see the spread widen to 20 percent and lose 14 percent. In light of these data shortcomings, building a portfolio of hedge funds is not simply a quantitative optimization problem. Nevertheless, expected returns and risks need to be balanced in arriving at the final portfolio. Using the views developed for each manager, the hedge fund investor must weigh expected returns against expected contribution to portfolio risk. Keeping in mind the caveats previously addressed, quantitative measures of risk will probably be considered. In addition, careful analysis of the expected payoffs to each hedge fund's strategy will be incorporated into the final decision. Potential constraints that will be forced on the portfolio arise from closed managers and fund illiquidity. The fact that some of the investors' favorite hedge funds may be closed clearly reduces expected returns. Illiquidity can also remove a fund from consideration, or can cause the investor to require higher expected returns to justify investing in the hedge fund.