Diversification in funds of hedge funds: is it possible to overdiversify?

Stephen J. Brown, Greg N. Gregoriou, Razvan Pascalau

Research output: Contribution to journalArticleResearchpeer-review

48 Citations (Scopus)

Abstract

Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this article, 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 variancereducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF 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 that increases with the number of hedge funds.

Original languageEnglish
Pages (from-to)89-110
Number of pages22
JournalReview of Asset Pricing Studies
Volume2
Issue number1
DOIs
Publication statusPublished - Jun 2012
Externally publishedYes

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