Diversification in funds of hedge funds: Is it possible to overdiversify? Review of Asset Pricing

Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds. (JEL G11, G29) †We thank Martin Gruber, Jerchern Lin, Richard Oberuc Sr. and Theodore Wagner for helpful discussions, as well as the extremely interesting comments and feedback from the referee and the Editor, Wayne Ferson. We would like to thank Sol Waksman at www.BarclayHedge.com for providing the data and also Beto Carminhato at Barclay Hedg