The Perils of Over-Diversification
By Stephen Brown, David S. Loeb Professor of Finance
Overdiversification does not imply meaningful risk reduction and leads to diminished returns and in extreme cases death of the fund, particularly when it becomes too expensive to perform the necessary due diligence.
Variety may be the spice of life, but when it comes to funds of hedge funds, too much diversification can be deadly.
Somewhat counter-intuitively, funds of hedge funds (FOHFs) that hold more than 20 underlying hedge funds are more, rather than less, risky than FOHFs with more moderate diversification, according to research by NYU Stern Finance Professor Stephen Brown and co-authors in their paper “Diversification in Funds of Hedge Funds: Is It Possible to Overdiversify?”
The researchers analyzed a new database that contained 3,767 FOHFs, separating, for the first time, the effects of diversification (the number of underlying hedge funds) from the scale (the magnitude of assets under management). They found that excess diversification actually increases the risk of exposure because of the common exposure to market tail risk.
“Those who market funds of hedge funds promote the ability to overcome tail risk exposure by extensively diversifying their hedge fund portfolios,” said Brown. “This is a fantasy. These funds are not an insurance policy against market tail risk.”
The size of the fund in terms of assets under management is the critical issue. Small FOHFs simply cannot afford the high cost of due diligence when there are a large number of underlying funds. Indeed, fewer than a quarter of all FOHFs can afford even the most minimal due diligence.
“Overdiversification does not imply meaningful risk reduction and leads to diminished returns and in extreme cases death of the fund, particularly when it becomes too expensive to perform the necessary due diligence,” warns Brown.