Diversification and Persistence in Hedge Funds

17 Pages Posted: 21 Nov 2005  

Craig W. French

Portfolio Engineering Laboratory

Damian B. Ko

Corbin Capital Partners, L.P.

David Abuaf

University of Chicago - Booth School of Business; Corbin Capital Partners, L.P.; University of Chicago

Date Written: October 31, 2005

Abstract

We examine the current fund of hedge funds universe, and find that funds of hedge funds report holding between 1 and 200 underlying funds, and generally hold 10-30, with close to 20 on average. We regress the performance of this universe on the number of holdings and find that return is practically orthogonal to the number of underlying hedge funds held. However, when we regress risk-adjusted return measured by the ex post Sharpe ratios of funds-of-hedge funds, we do find a statistically significant positive relation over 5-year periods; this seems consistent with our findings that diversification reduces volatility.

We also examine the diversification effect on total risk reduction in a variety of hedge fund strategies, and we report the total risk as a function of the number of underlying hedge funds for four strategies: Equity Long/Short, Arbitrage, Event-Driven and Distressed, and Global Macro. We find that the asymptotic level of total intra-strategy systematic risk varies across the strategies, from about 3% to about 10% annualized standard deviation, while diversification across funds within each strategy reduces total portfolio annualized standard deviation by about 40% - 50%, at 15 to 25 holdings.

Finally, we examine whether there is persistence in the risks and returns of hedge funds, and find persistence in returns at up to 2-year horizons and strong persistence in total risk at up to 4 year horizons.

Keywords: Hedge Fund, Diversification, Persistence

JEL Classification: G11

Suggested Citation

French, Craig W. and Ko, Damian B. and Abuaf, David, Diversification and Persistence in Hedge Funds (October 31, 2005). Available at SSRN: https://ssrn.com/abstract=850304 or http://dx.doi.org/10.2139/ssrn.850304

Craig W. French (Contact Author)

Portfolio Engineering Laboratory ( email )

115 Pondview Drive
Washington Crossing, PA Pennsylvania 18977
United States
6108446040 (Phone)

Damian Bongjoon Ko

Corbin Capital Partners, L.P. ( email )

9 West 57th Street
25th Floor
New York, NY 10019
United States
212-634-7354 (Phone)
212-634-7399 (Fax)

David N. Abuaf

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Corbin Capital Partners, L.P. ( email )

9 West 57th Street, 25th floor
New York, NY 10019
United States
212 634 7352 (Phone)
212 634 7399 (Fax)

University of Chicago ( email )

1101 East 58th Street
Chicago, IL 60637
United States

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