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New Research Shows Diversification of Funds of Hedge Funds Increases Risk

Investment Weekly News
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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.

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