Funds of hedge funds (FoF) diversify investments across hedge funds to achieve steady return streams. Some FoFs diversify within a single hedge fund strategy (category), while others diversify both within and across hedge fund categories. Does the latter enhanced approach to diversification outperform the former? In their December 2010 paper entitled “Diversification Strategies and the Performance of Funds of Hedge Funds”, Na Dai and Hany Shawky contrast the performances of FoFs that diversify within one category versus those that diversify both within and across categories. Using monthly performance data for two broad samples of live and dead FoFs with different diversification metrics spanning 1994 through 2008, they find that:
- Over the entire sample period, the mean monthly returns in excess of LIBOR for the two FoF samples are -0.10% and 0.04%, with respective standard deviations 2.53% and 2.35%.
- Groups of FoFs with high diversification tend to have greater average excess returns and 7-factor alphas, and perhaps lower average volatilities, than groups of FoFs with low diversification.
- FoFs that diversify both within and across hedge fund categories tend to outperform those that diversify within a single hedge fund category. The level of outperformance is roughly in the range 0.5% to 0.75% annually.
- The benefit of diversification is greater for large FoFs (assets under management $600-700 million) than small ones.
- Level of FoF diversification relates positively to fund survival.
- Excluding data for 2008 does not substantially affect findings.
In summary, evidence from performance data for funds of hedge funds indicates that diversifying across fund categories (probably indicating diversification across asset classes) offers greater reward than diversifying within a single category, and that effective diversification requires scale.
In general, results suggest that broad definitions of investment diversification may have inherent advantages over narrow definitions.
