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

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