Diversification in Hedge Fund Portfolios

• Main Author: TEO, Melvyn
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2013
• Subjects: hedge funds; diversification; investment portfolio; Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/bnp_research/22; https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=1021&context=bnp_research
• Institution: Singapore Management University

We explore the diversification benefits of increasing the number of hedge funds in an investment portfolio. Conventional wisdom suggests that investors should construct a portfolio of 20 to 30 hedge funds in order to achieve a reasonably low portfolio variance. We show using Monte Carlo simulations that the marginal benefit of including an additional hedge fund in a fund portfolio diminishes significantly once the number of hedge funds increases beyond ten. Specifically, the annualized standard deviation of a fund portfolio diminishes from 16.55 percent to 7.40 percent as we increase the number of funds from one to ten. However, the standard deviation only drops by an additional 0.55 percent when we increase the number of funds to 15. Investors can crimp portfolio variance further by spreading their capital judiciously across multiple hedge fund strategies. These findings are especially relevant for investors who are transiting from indirect investments via funds of hedge funds to direct investments in single-manager hedge funds.