What percentage of their portfolio should investors allocate to hedge funds? The only available answers to the above question are set in a static mean-variance framework, with no explicit accounting for uncertainty on the active manager's ability to generate abnormal return, and usually generate unreasonably high allocations to hedge funds. In this paper, we apply the model introduced in Cvitanić, Lazrak, Martellini and Zapatero (2002b) for optimal investment strategies in the presence of

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... ain abnormal returns to a database of hedge funds. We find that the presence of model risk significantly decreases an investor's optimal allocation to hedge funds. Another finding of this paper is that low beta hedge funds may serve as natural substitutes for a significant portion of an investor risk-free asset holdings. Sick as well as seminar participants at Calgary, SFU and UBC for very useful comments and suggestions. All errors are, of course, the authors' sole responsibility.