Q. So, all we ever hear about is how important diversification is… but this term makes it sound like there can be “too much of a good thing.”
A. Yep, and its particularly true of funds of hedge funds, one of the most common ways for investors to get in to the hedge fund world, whether through mutual funds that allocate out to multiple hedge fund managers, or the more traditional privately placed “fund of funds”. Fact is, more underlying investments is definitely not always better… and, beyond a certain number, is usually worse.
Q. So that’s what the track records show, or that’s a point of academic debate?
A. It used to be a point of academic debate, but newer research using the actual performance records shows pretty clearly that once you get over 20 or 25 underlying investments, the FoF peformance starts to suffer… they did really poorly in the crash, contrary to expectations.
Q. But why would that be? Why isn’t more diversification equal to more risk reduction?
A. Its one of those wonderful theory versus practice issues. Many FoFs sold themselves on the basis of uber-diversification… but there was a very practical problem. They couldn’t really afford to do deep dive due diligence on more than a dozen or two… its expensive to do HF DD. So if you had unlimited information about the underlying investments, maybe that model works; but given how hard it can be to learn what you need about a particular fund, it doesn’t.
Q. So the FoFs that were investing in scores and scores of hedge funds didn’t really understand their investments all that well?
A. Exactly. And that led to both poor manager selection and lots of accidental correlation… which became evident in the crash.