Fund of Hedge Funds Diversification & the Importance of Life Cycle
Aug 11th, 2009 | Filed under: CAPM / Alpha Theory, Today's Post(By: Michael Newman, CAIA, AllAboutAlpha.com Editorial Board)
How much variety is too much?
Diversification is often the mantra of hedge fund investors. But a forthcoming academic paper from State University of New York (SUNY) professors Greg Gregoriou and Razvan Pascalau suggests that the optimal number of underlying hedge funds within a fund of hedge fund portfolio may actually be as low as 6-10. Their study is one of the first to utilize actual data culled from a hedge fund database and move beyond theorizing about a magic number.
While that is only one conclusion to be drawn from their data analysis, the primary thrust of the paper is to demonstrate empirically that the number of “HFs included into a FOF has a negative and significant impact on the volatility of returns while having less of an impact on the actual returns.”
Although their findings regarding the volatility of returns has long been an obvious, intuitive conclusion from the application of Modern Portfolio Theory and general rules of diversification, the academic literature had yet to analyze actual FOF data. Moreover, their observations regarding the limited impact on performance will provide plenty of fodder for those on both sides of the debate about just how much alpha a FOF manager provides.
Getting the Lay of the Land
The paper is equally important for investors in FOFs seeking to get the lay of the land. The paper begins with a brief review of the academic literature surrounding FOF diversification, much of which seems to predate the tremendous growth of the FOF industry in recent years. In fact, the bulk of the studies cited were written prior to 2002. This should caution us from jumping to too many conclusions and remind us that we are, in a sense, observing a moving target.
Fortunately, the data the authors use for their analysis, from the Barclay hedge fund database, runs through the end of 2008. It’s especially useful for illuminating the contours of the current FOF marketplace. As an example, of the over 2000 live FOFs in the Barclay hedge fund database, 70% have 30 underlying managers or less. Similarly, the paper cites a MARHedge survey that found two-thirds of FOFs have between 9-11 managers. More…
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