Ebook Hedge Fund Diversification: How Much Is Enough?
They were exotic products created by unregulated, renegade stock-pickers and exclusively held by a private club of high-net-worth individuals for financial snobbery motives. They have progressively become the darlings of the investment industry, as evidenced by financial publications, analysts’ reports, boardrooms and even happy hour cocktails. Their success was fuelled by the wealth created by the long bull equity market of the 1990s, and is now supported by the difficult and highly volatile environment that has prevailed since the early 2000s. Indeed, by focusing on absolute performance and abstracting from benchmarks, hedge funds are able to generate superior returns in virtually all types of market environments. Consequently, they offer the much-needed diversification to portfolios invested in traditional asset classes such as equities and bonds. This provides a strong argument for using them in wealth management and contributes to making this new asset class – or new way to manage traditional asset classes – an increasingly popular investment choice.
However, we all know that there is “no such thing as a free lunch” in finance. Thus, private and institutional investors willing to include hedge funds in their portfolios must realize that to deliver their favorable return/risk characteristics, hedge funds must carry additional risks, which are not common to traditional stock and bond investments. These risks are inherent to the strategies pursued, the instruments and markets used, the amount of leverage employed, and last, but not least, the specific skills of the selected hedge fund managers.
Since choosing a bad manager may easily wipe out all the benefits of a hedge fund allocation, investing in only one hedge fund is likely to be sub-optimal. The reasons are threefold. Firstly, dramatic performance differentials between competing funds raise the issue of whether a single investment instrument can deliver consistent returns close to those of the broad hedge-fund indices that are used at the strategic asset-allocation level. Secondly, a number of individual hedge funds have collapsed under the weight of spectacular frauds or investment debacles (Manhattan Capital Management, Maricopa Investment Corporation, Lipper Convertible Arbitrage, etc.). This has raised concerns among investors, who often lack sufficient information to evaluate comparative hedge fund performance and to perform the necessary exhaustive on-site due diligence checks. Finally, investing only with managers who have a good reputation and an established track record does not provide a complete hedge, as illustrated by the debacle of the brain trust that was Long Term Capital Management LP.
Consequently, risk-conscious investors are coming back to the central tenet of modern portfolio theory, namely, diversification. By combining several hedge funds with differing return distributions and risk profiles in a portfolio, investors are able to diversify specific risk away and ensure a more disciplined exposure to the overall hedge fund asset class. This is likely to result in better long-term risk-adjusted returns. Those willing to avoid the logistical problems and record-keeping headaches of tracking several hedge funds may even delegate the portfolio construction and monitoring activities to a fund of hedge funds. This is the preferred investment structure for most institutional investors, since it gives them instant diversification and frees them from the responsibility of monitoring managers.
Funds of hedge funds were initially diversified across investment styles, sectors and/or regions. However, more recently, funds of hedge funds focusing on a single investment style, a particular asset class, a single sector or region have also emerged. They are usually more concentrated in terms of risks as well as in terms of number of underlying hedge funds than the larger diversified funds of funds. Their adage could be: "Put all your eggs in one basket, but then don't take your eyes off that basket". Nevertheless, focused-hedge fund managers still invest in more than one underlying fund and therefore rely on the risk-reduction power of diversification.
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