Investors understood the benefits of diversification well before Harold Markowitz published his Nobel Prize‐ winning research in 1952. The old adage "Don't put all your eggs in one basket" predates Markowitz's work probably by centuries. Markowitz's contribution-and that of others in the field of portfolio theory-was to help investors quantify the diversification benefit they achieved by adding more investments to their portfolio.
Hedge fund investors have implemented the prescription of diversification in many ways. Institutional investors and funds of hedge funds diversify across asset classes, strategies, geographic focus, and other dimensions. Such investors often attempt to achieve diversification across these dimensions by allocating to 30 or more single hedge funds. But such broad diversification in hedge funds portfolio.
Diversification declines as the number of hedge fund managers in a portfolio increases.
Adding a few managers can add diversification benefits to a portfolio, but at some point more may not be better.
In order to demonstrate the idea of diversification benefits are achievable even when allocating to relatively few hedge fund managers, we compared the risk‐reward characteristics for three sets of investments. The first was a simple allocation to stocks, bonds and US Treasury Bills.
The second portfolio was the combination of stocks, bonds and T‐Bills with a 10 percent allocation to a broad group of 2,000 hedge funds as represented by the HFRI Fund‐Weighted Composite Index. Finally, we replaced the index with a bundle of five managers that Hedgeharbor represents with the same overall allocations to equities, bonds and T‐Bills. Chart 1 shows the risk‐reward characteristics for these three sets of portfolios.
The time frame for this analysis was the common time period of the five Hedgeharbor managers. The performance for this common time period began in March 2008-at the onset of the global financial crisis- and covers the aftermath of the crisis as well.
During this period, not surprisingly, given the time period covered, an investment in a standard combination of equities, bonds and US Treasury Bills produced the highest volatility of the three portfolios. Adding a 10 percent allocation of the broad hedge fund index reduces the volatility, but contributed negatively to returns during this period. Replacing the broad hedge fund index with a 10 percent allocation to the Asset Alliance Hedgeharbor five‐manager bundle, however, both increased returns and lowered volatility.
The key to achieving these diversification benefits of course is careful manager selection. That means devoting resources and effort to identifying and evaluating the managers that ultimately go into the investor's portfolio.
Performing research and conducting due diligence reviews on a large number of hedge funds typically requires greater resources than many smaller investors can or are willing to devote to a relatively small percentage of their overall portfolio. By focusing these resources on fewer managers, the investor can achieve the benefits of such investments at a more reasonable cost.
Of course, by being more concentrated in a smaller number of managers, the risk of failure of any one of them is magnified. However, in this example any one manager represents only 2.5 percent of the larger overall portfolio, so even if one manager suffers a large loss or some idiosyncratic risk event, the impact on the portfolio is manageable.
Some smaller institutional investors will still chose to allocate to funds of hedge funds as a means of gaining alternative investments exposure. It is by conducting research and due diligence on a large number of single manager funds and exhibiting skill in constructing portfolios of these managers that funds of funds provide the greatest benefit to investors. Nevertheless, as we have shown here, it is possible for an investor to gain the diversification benefit of hedge funds by investing directly in a limited number of single managers.
Asset Alliance Hedge Harbor stands ready to assist investors in identifying quality single managers as well as multi‐ manager products that meet their investment goals and objectives.