Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify?

40 Pages Posted: 22 Jul 2009 Last revised: 9 Jul 2011

Stephen J. Brown

New York University - Stern School of Business

Greg N. Gregoriou

SUNY College at Plattsburgh; McGill University

Razvan C. Pascalau

SUNY College at Plattsburgh - School of Business and Economics; University of Navarra

Date Written: July 7, 2011

Abstract

Samuelson (1967) argues that as a general matter it is easy to show that investors should be maximally diversified. For this reason many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FOFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance reducing effects of diversification peter out once FOFs hold more than 20 underlying hedge funds. Yet the majority of FOFs are more diversified than this. We find a new and surprising result that this excess diversification actually increases the left tail risk exposure of FOFs particularly once we account for the extent to which hedge fund returns are smoothed. Furthermore the average FOF in our sample is more exposed to left tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns which we attribute to the cost of necessary due diligence which increases with the number of underlying hedge funds in the FOFs .

Keywords: Funds of Hedge Funds, Diversification, Tail Risk Exposure, Hedge Funds

JEL Classification: G23, G11, C32

Suggested Citation

Brown, Stephen J. and Gregoriou, Greg N. and Pascalau, Razvan C., Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify? (July 7, 2011). Available at SSRN: https://ssrn.com/abstract=1436468 or http://dx.doi.org/10.2139/ssrn.1436468

Stephen J. Brown (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0306 (Phone)
212-995-4233 (Fax)

Greg N. Gregoriou

SUNY College at Plattsburgh ( email )

Plattsburgh, NY 12903
United States

McGill University ( email )

1001 Sherbrooke St. W
Montreal, Quebec H3A 1G5
Canada

Razvan C. Pascalau

SUNY College at Plattsburgh - School of Business and Economics ( email )

101 Broad Street
Plattsburgh, NY 12901
United States
518-564-4193 (Phone)

University of Navarra ( email )

Camino del Cerro del Aguila, 3
Pamplona, Navarra 31080
Spain

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