Hedge fund manager-diversification vs. hedge fund strategy-diversification

Pundits often like to say that long term investing success is usually the result of sector selection, not security selection.  Perhaps that’s why so many mutual fund managers are accused of being closet indexers.  But hedge funds are different.

As Girish Reddy, Peter Brady and Kartik Patel pointed out in the Winter 2007 edition of the Journal of Alternative Investments (“Are Funds of Funds Really Multi-manager Funds with Extra Fees? ^[2]“) there is a relatively tight dispersion of returns among managers using the same traditional strategy, e.g. equities, fixed income, etc., and a relatively wide dispersion of returns across those traditional strategies.  Conversely, they found a relatively wide dispersion of returns among managers using the same alternative strategy, e.g. long/short equity, market neutral, and a relatively small dispersion of returns across those different alternative strategies.

The trio concluded that multi-manager hedge funds – which can rotate between strategies, but not across managers other than a select few in-house managers – may miss-out on these opportunities.  Funds of funds, which can rotate across both strategies and managers, are better able to exploit opportunities across both dimensions according to the trio of authors.

Which begs the question: What about a fund of funds that is constrained from rotating among strategies altogether? Assuming Reddy, Brady and Kartik are correct that the opportunity for hedge funds of funds lies in manager selection, not strategy selection, then one might expect a sector-specific fund of funds to perform nearly as well as an unconstrained fund of funds.

But a recent paper ^[3] by Na Dai and Hany Shawky of the University at Albany finds this intuition may be off.  The duo finds funds of funds that diversify across both strategies and managers are able to generate higher alphas.  The chart below, created with data in Table 2 of the paper, shows that funds of funds with more numbers of “focuses” (TASS) and which are “diversified” (CISDM) produce higher Fung & Hsieh Alphas:

 ^[4]

But they also found that the benefits of strategy diversification applied mainly to large funds of funds.

 ^[5]
Finally, Dai and Shawky confirm the intuition that more diversified funds of funds had lower failure rates; anyone who invested in a Madoff feeder fund they believed was a “diversified” fund of funds doesn’t need any further evidence. While traditional long-only investments may be all about beta, alternative investments are all about alpha or idiosyncratic manager risk.  So any portfolio of hedge funds that is able to rotate among managers is sure to offer alpha opportunities.  But it also appears that the ability to rotate among different hedge fund strategies remains an important source of out-performance.