Finding the sweet spot of hedge fund diversification

Hedge funds are often thought of as being high-risk investments and many investors in the past have shied away from them for fear of making large losses. However, over the recent years, hedge funds have generally substantially outperformed equities, with much lower volatility. As a consequence, they are now in strong demand, particularly when one remembers that any risk associated with hedge fund investing diminishes in importance when the funds are repackaged into fund of funds products. Once one admits that portfolio diversification reduces manager risk, there is a fundamental question that needs to be addressed, namely, the optimal number of hedge funds to effectively benefit from diversification. In this paper, using a large database of more than 6000 hedge funds, we provide evidence that from a pure market risk perspective, a small number of funds is sufficient to reap most of the diversification benefits, whatever the considered strategy. In addition, for some strategies, too much diversification results in undesirable side effects in the higher moments of the return distribution. Thus, while a fund of hedge funds may mitigate the negative effects of a hedge fund failure through diversification, too much diversification is also likely to result in diworsification.