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The Perils of Hedge Fund Diversification

Preview of the 2012 Investment Innovation Conference.

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applesAs a speaker at this fall's Investment Innovation Conference in San Diego (November 6-8), Stephen Brown, the David S. Loeb Professor of Finance at New York University's Stern School of Business, will speak on funds of hedge funds for institutional investors. In advance of the conference, we asked Stephen a few questions about his research, which centres on due diligence, diversification and tail risk. To find out more about Stephen's presentation and the Investment Innovation Conference, click here.

Do funds of hedge funds still offer diversification benefits for institutional investors?

I think there's been a bit of a misconception about funds of hedge funds. The role of funds of hedge funds is to provide institutional access to hedge funds. They have a fiduciary responsibility to perform all necessary operational due diligence on behalf of their institutional clients. What I sense and what my research shows is that a lot of funds of hedge funds think they meet their fiduciary obligations merely by being sufficiently diversified. Who cares if one or two of their constituent funds fail?

Diversification alone is insufficient to meet their fiduciary responsibilities. In fact, diversification can actually make the situation worse, in two important dimensions. First, diversification can actually increase tail risk exposure. Second, effective operational due diligence is costly. The more funds you invest in the more expensive is the necessary due diligence.

A lot of people believe, incorrectly, that hedge fund diversification can reduce or even eliminate tail risk exposure. My research shows that this is a false presumption. Diversification actually increases tail-risk exposure. This is not just during the recent financial crisis.

The reason for this is that hedge funds are designed for long-term investors. These patient investors earn rents from providing the liquidity that allows hedge funds to buy when no one else is willing to buy and to sell when no one else is willing to sell. As a consequence, when you have a liquidity crisis, even though there are many different kinds of hedge fund strategies, they all tend to be exposed one way or another to the same risk factor. Funds of hedge funds, by their very nature are heavily exposed to tail risk. All the hedge funds they invest in have different investment strategies and follow different approaches.  However, when you take a portfolio of them, you distill the tail risk each is exposed to and concentrate it. "We all fall down together"

So diversification actually makes the situation worse, at least so far as tail risk is concerned. That's factor number one. Factor number two is that funds of hedge funds are still responsible for performing necessary due diligence. Operational due diligence is an expensive business. The expense necessarily increases with the number of funds the fund of hedge fund is investing in.

Why doesn't diversification work?

A lot of people in the hedge fund of hedge fund business have expressed the view that there is some optimal degree of diversification. I think that's a wrongly posed question. The correctly posed question is how much due diligence can you afford? Due diligence is an expensive operation. The larger the fund, the easier it is to provide the necessary due diligence. For this reason, operational due diligence is a fixed cost to the enterprise, a cost per dollar invested that decreases as the assets under management rise. By the same token however, this cost necessarily increases with each fund that you invest in.

A number of very large hedge funds of funds invest in many underlying hedge funds. In a study I recently completed I found that there were seven or eight of them were invested in between 300 to 400 hedge funds. During the financial crisis, all of these overdiversified funds failed. This is the point that I've been stressing. If you cannot afford to do necessary operational due diligence there is a good chance you will fail. On the other hand there are opportunities for well-run funds to attract capital after the financial crisis. The number of funds of funds has fallen since the crisis. Assets under management have also fallen. But the assets under management per fund has actually increased. This means that there are opportunities for well-run funds that actually do operational due diligence, which my research shows can add up to 260 basis points of return per annum.

The problem is finding those funds, given the number of fund of funds that invested with  Bernie Madoff.

The Madoff situation is a really interesting case study because there was absolutely no operational due diligence. I actually looked at some of the offering materials for European funds of funds that invested in Madoff. The most elementary forensic analysis of these materials indicate serious problems. The numbers in the reported holdings do not match up to the description in the annual report and almost all of the numbers curiously end in the numerals 6,7 8 and 9. It is clear that no one took any of these reports very seriously.

How many underlying funds are adequate for diversification?

This is the question that has occupied the minds of people in the funds of funds business. I think it's a false question. The real question is how much due diligence can you afford? If you don't have enough money to do operational due diligence, then you shouldn't be investing. I have a very simple formula: annual gross revenues from the fund of hedge fund operation divided up among the funds they are investing in should be no less than $12,500, the minimal cost of an operational due diligence on a fund basis that should be performed at least once a year. This is a very conservative test, as the gross revenue number does not account for salaries and wages, heat light and power and other necessary costs of running the business. Surprisingly, the data show that only about a quarter of funds of hedge funds in the United States meet this very simple test.

To learn more about the Investment Innovation Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Garth Thomas to be considered, as limited space available.

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