Implicit in the recent financial market yo-yo that caught hedge funds and investors alike off guard was the notion that diversification – as simple as being allocated to both stocks and bonds and as complex as having money in numerous strategies and concepts – should in the end generate offer both returns and protection.
Yet while early indications are that hedge funds managed to weather the early August rout in decent form, indications are that FoHFs may once again have felt the pain of being tied into managers and strategies that didn’t provide the kind of returns or protection they were supposed to.
Indeed, according to a recent academic paper, for funds of hedge funds (FoHFs) in particular having too much moderation is actually a bad thing, in that different hedge fund managers and strategies spread out across the food chain, so to speak, is actually bad for investors’ health.
While logically it would make sense that investors would be protected by being with a FoHF that is well diversified, the research finds that FoHF portfolios with more than 25 underlying managers have weaker performance and increased tail risk.
The study, written by Stephen Brown, Greg Gregoriou and Razvan Pascalau of New York University’s Stern School of Business (click here to download from SSRN), notes that a misplaced emphasis on diversification may be contributing to performance degradation and increased tail risk in FoHFs.
“FoHFs that efficiently diversify away business risk considerations do not necessarily provide any protection against the common factor represented by left tail market risk exposure. Indeed, FoHFs diversification concentrates this risk,” notes the study. “We would expect that the larger the number of underlying hedge funds in the FoHFs, the more exposed the FoHFs should be to these negative market conditions.”
To prove their case, Brown and his research team analyzed the impact of diversification on the performance of 3,767 FoHFs that reported monthly returns and the number of their underlying fund holdings to the BarclayHedge database between January 2000 and March 2010.
What they found was that the benefits of diversification in terms of reducing monthly standard deviation tended to hit a wall at between 10 and 20 underlying hedge funds, while diversification beyond 25 funds in most cases led to a significant reduction in relative performance. The chart below illustrates performance as a function of the number of underlying hedge funds.
Their analysis also revealed “over-diversification” across 25 or more hedge funds actually increased left tail risk for FoHFs.
The results of the study indicate many FoHFs are over-diversified. According to the authors’ findings, almost half the FoHFs in the BarclayHedge database had more than 20 underlying funds – the point at which the risk-reducing benefits of diversification tend to plateau.
More than a third of FoHFs held more than 25 underlying funds where diversification has a negative impact on performance and tail risk, the paper notes.
Key in the study’s findings is the fact that all hedge fund strategies are in some form or other exposed to liquidity risk, which as most know from 2008 – and were reminded of in early August 2011 – trumps all else when investors are running for the exits.
Another key factor: due diligence costs. It doesn’t take a rocket scientist to figure out that the more underlying managers to monitor, the more it’s going to cost, which in turn is dictated by the amount of assets under management the FoHF has.
“The larger the FoHF, the more likely they can afford more diversification, because they have greater economies of scale,” according to the report.
As due diligence is costly and information on hedge funds is difficult to obtain, Brown argued smaller hedge funds should specialize and invest only in the funds for which they have sufficient information. This implies smaller FoHFs may actually capture more alpha if they were relatively under-diversified.
The performance fee model also provides another reason to keep diversification within limits. As the authors note, the bigger the number of underlying funds, the larger the accumulation of incentive fees, which becomes a fixed charge payable by the investor whether or not the FoHF performs poorly.
To be sure, spreading out risk and not putting all your eggs in one basket is still advisable. It’s just better not to have too many baskets – or frankly too many eggs. Besides, what do “they” know anyway?