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.
hedge funds, diversification, investment portfolio
Finance and Financial Management
Hedge Fund Insight
BNPP Hedge Fund Centre
City or Country
Teo, Melvyn. 2013 April. Diversification in Hedge Fund Portfolios. Hedge Fund Insight, 2-7.