Hedgeharbor Navigator

May2012

Diversification: Can Less Be More?

Diversifying an investment portfolio by including hedge funds is possible to achieve by allocating to a relatively small number of managers. A smaller investorsuch as a family office or small institutionconsidering adding hedge funds to their portfolio can achieve diversification with a relatively small number of managers.
Investorsunderstoodthebenefitsofdiversificationwell beforeHaroldMarkowitzpublishedhisNobelPrize winningresearchin1952.TheoldadageDontputall youreggsinonebasketpredatesMarkowitzswork probablybycenturies.Markowitzscontributionand thatofothersinthefieldofportfoliotheorywasto helpinvestorsquantifythediversificationbenefitthey achievedbyaddingmoreinvestmentstotheirportfolio. Hedgefundinvestorshaveimplementedthe prescriptionofdiversificationinmanyways. Institutionalinvestorsandfundsofhedgefunds diversifyacrossassetclasses,strategies,geographic focus,andotherdimensions.Suchinvestorsoften attempttoachievediversificationacrossthese dimensionsbyallocatingto30ormoresinglehedge funds.Butsuchbroaddiversificationinhedgefunds maynotbenecessarytoreducetheoverallriskina portfolio. Someresearchsuggeststhattheadditionalbenefitsof diversificationdeclinesasthenumberofhedgefund managersinaportfolioincreases.1Addingafew managerscanadddiversificationbenefitstoaportfolio, butatsomepointmoremaynotbebetter. Inordertodemonstratetheideaofdiversification benefitsareachievableevenwhenallocatingto relativelyfewhedgefundmanagers,wecomparedthe riskrewardcharacteristicsforthreesetsof investments.Thefirstwasasimpleallocationtostocks, bondsandUSTreasuryBills.Thesecondportfoliowas
Asanexample,seeHowManyHedgeFundsAreNeededto CreateaDiversifiedFundofFunds?,AssetAllianceCorp., 2002
1

thecombinationofstocks,bondsandTBillswitha10 percentallocationtoabroadgroupof2,000hedge fundsasrepresentedbytheHFRIFundWeighted CompositeIndex.Finally,wereplacedtheindexwitha bundleoffivemanagersthatHedgeharborrepresents withthesameoverallallocationstoequities,bondsand TBills.Chart1showstheriskrewardcharacteristicsfor thesethreesetsofportfolios. Thetimeframeforthisanalysiswasthecommontime periodofthefiveHedgeharbormanagers.The performanceforthiscommontimeperiodbeganin March2008attheonsetoftheglobalfinancialcrisis andcoverstheaftermathofthecrisisaswell. Chart1:RiskRewardCharacteristics
6.0% HHBundle

5.5%
CompoundROR

5.0%

HH Standard+ HFRI

4.5%

HH Standard

4.0% 9.0% 10.0% 11.0% 12.0% StandardDeviation

Duringthisperiod,notsurprisingly,giventhetime periodcovered,aninvestmentinastandard combinationofequities,bondsandUSTreasuryBills producedthehighestvolatilityofthethreeportfolios. Addinga10percentallocationofthebroadhedgefund indexreducesthevolatility,butcontributednegatively

toreturnsduringthisperiod.Replacingthebroadhedge fundindexwitha10percentallocationtothe Hedgeharborfivemanagerbundle,however,both increasedreturnsandloweredvolatility. Thekeytoachievingthesediversificationbenefitsof courseiscarefulmanagerselection.Thatmeans devotingresourcesandefforttoidentifyingand evaluatingthemanagersthatultimatelygointothe investorsportfolio. Performingresearchandconductingduediligence reviewsonalargenumberofhedgefundstypically requiresgreaterresourcesthanmanysmallerinvestors canorarewillingtodevotetoarelativelysmall percentageoftheiroverallportfolio.Byfocusingthese resourcesonfewermanagers,theinvestorcanachieve thebenefitsofsuchinvestmentsatamorereasonable cost. Ofcourse,bybeingmoreconcentratedinasmaller numberofmanagers,theriskoffailureofanyoneof themismagnified.However,inthisexampleanyone

managerrepresentsonly2.5percentofthelarger overallportfolio,soevenifonemanagersuffersalarge lossorsomeidiosyncraticriskevent,theimpactonthe portfolioismanageable. Somesmallerinstitutionalinvestorswillstillchoseto allocatetofundsofhedgefundsasameansofgaining alternativeinvestmentsexposure.Itisbyconducting researchandduediligenceonalargenumberofsingle managerfundsandexhibitingskillinconstructing portfoliosofthesemanagersthatfundsoffunds providethegreatestbenefittoinvestors.Nevertheless, aswehaveshownhere,itispossibleforaninvestorto gainthediversificationbenefitofhedgefundsby investingdirectlyinalimitednumberofsingle managers. Hedgeharborstandsreadytoassistinvestorsin identifyingqualitysinglemanagersaswellasmulti managerproductsthatmeettheirinvestmentgoalsand objectives.