Modern financial theory holds that a diversified portfolio of securities is the most efficient way for an investor to access an asset class. Idiosyncratic risk, the risk associated with an individual stock say, can be diversified away and therefore theory holds that investors don't achieve any additional return for holding concentrated portfolios of their favorite stocks. It's an idea that makes a lot of intuitive sense. Consequently, you can invest in equities and possess no particular stock-picking skill by using an index fund. Hundreds of billions of dollars are invested passively in this way. Based on many decades of performance from public equities (although admittedly the last decade was no walk in the park) this is a sound strategy.
Using the same construct with hedge funds produces a different result. A key underlying assumption in the "diversification is good" approach is that the underlying asset class has a positive return. However, as I show in my book The Hedge Fund Mirage, if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. The average hedge fund $ generated a negative return with respect to the risk-free rate. There are great hedge funds and happy clients, but these are not the norm. Since I wrote my book hedge funds have continued to provide empirical support for my findings. YTD performance for the HFRX Global Hedge Fund Index is 1.2% through June - actually outpacing treasury bills (which yield approximately 0%) but for the tenth straight year lagging a simple 60/40 stocks/bonds portfolio.
Since hedge funds in aggregate have been a bad investment, the only way to win as an investor is to be better than average at picking managers. Some people are. But since diversification is intended to draw you towards the average return, and the average return is in this case not something you want, the rational use of hedge funds in an investment portfolio is to select only two or three where you have insight and high conviction. Adding more funds creates more diversification, which for a hedge fund investor is a bad thing.
Some of the smartest people in the hedge fund industry are the hedge fund managers themselves. You'll rarely hear them advocating a diverse portfolio of hedge funds. They already understand the mediocrity and lack of return persistence so prevalent amongst their peers. And often the happiest clients are those who don't have many hedge funds, but made a few good choices with a small part of their portfolio. For if a diversified hedge fund portfolio is bad, so is a large allocation to hedge funds. A 1-2% allocation to two or three funds takes the best of what hedge funds have to offer. Hedge fund returns have steadily deteriorated as assets have grown, just as is the case with individual funds.
But the consultants and advisors who promote a diversified portfolio of hedge funds as an important component of an institution's overall portfolio are misusing the Capital Asset Pricing Model. A diversified hedge fund portfolio is The Dumbest Idea in Finance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.