While everyone admits that hedge fund portfolio diversification reduces manager risk, the question of the optimal number of funds in a fund of funds (multi-manager portfolios) remains commonly overlooked. The typical mistake of misusing diversification derives from the classic standpoint that more funds in the portfolio ultimately enhances its diversification. This is not so.
What Is The Optimal Number Of Funds In Hedge Fund Of Funds?
Numerous studies, including our own research, evidence that a small number of funds is sufficient to yield the diversification benefits, while excessive increasing the size of the portfolio may lead to increased risk effectively loosing such benefits. The key points of the sensible diversification practice could be summarized as follows.
- The optimal number of funds in a multi-manager portfolio should be in the range of 11-20. Increasing the number of funds over the above limit brings no significant risk enhancement or performance improving.
- Increasing a number of funds leads to excessive negative skewness and kurtosis for Event Driven and Fixed Income Arbitrage funds. Thus, diversification across these strategies may create problems rather than mitigate risks. Increasing a number of funds over 10 results in an excessive intercorrelation across fund's constituents.
- Portfolios of over 20 funds tend to exhibit a high correlation with hedge fund indices (over 0.9). In that respect, it makes sense to invest into indices rather than choosing 20+ fund portfolios.
Note that the Portfolio component of Risk Shell automatically calculates the portfolio Diversification Effect Ratio every time you run a correlation-related analysis. Try to achieve, at least, 0.5 DE Ratio to ensure a reasonable portfolio diversification.