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New Research Shows Diversification of Funds of Hedge Funds Increases Risk

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Those who market funds of hedge funds promote the ability to overcome tail risk exposure by extensively diversifying their hedge fund portfolios. This is a fantasy. These funds are not an insurance policy against market tail risk.

NEW YORK--It is widely believed that a diversified hedge fund portfolio strategy is an effective hedge against adverse market movements. New research by NYU Stern Finance Professor Stephen Brown, with co-authors Greg Gregoriou and Razvan Pascalau of SUNY College at Plattsburgh School of Business and Economics, shows this is not the case: well-diversified funds of hedge funds are more sensitive to risk than is the average hedge fund in extreme market conditions.

Examining a new database of 3,767 funds of funds that separates out, for the first time, the effects of diversification (the number of underlying hedge funds) from the scale (the magnitude of assets under management), the authors find that once a fund of funds holds more than 20 underlying hedge funds, the benefit of diversification substantially diminishes. In fact, excess diversification actually increases their risk 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. This is a fantasy. These funds are not an insurance policy against market tail risk,” said Professor Stephen Brown.

Well-diversified hedge fund strategies have other undesirable characteristics:

  • An increase in tail risk is accompanied by lower returns
  • The authors attribute lower returns to the cost of necessary due diligence, which is expensive and increases with the number of underlying hedge funds in a fund of funds

To read the full paper, forthcoming in the Review of Asset Pricing Studies, visit: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1436468

To speak with Professor Stephen Brown, please contact him directly at 917-535-7317, sbrown@stern.nyu.edu, or contact Rika Nazem in NYU Stern’s Office of Public Affairs, 212-998-0678, rnazem@stern.nyu.edu.