1. Hedgeharbor Navigator
May 2012
Diversification: Can Less Be More?
Diversifying an investment portfolio by including hedge funds is possible to achieve by
allocating to a relatively small number of managers. A smaller investor—such as a family office
or small institution—considering adding hedge funds to their portfolio can achieve
diversification with a relatively small number of managers.
Investors understood the benefits of diversification well the combination of stocks, bonds and T‐Bills with a 10
before Harold Markowitz published his Nobel Prize‐ percent allocation to a broad group of 2,000 hedge
winning research in 1952. The old adage “Don’t put all funds as represented by the HFRI Fund‐Weighted
your eggs in one basket” predates Markowitz’s work Composite Index. Finally, we replaced the index with a
probably by centuries. Markowitz’s contribution—and bundle of five managers that Hedgeharbor represents
that of others in the field of portfolio theory—was to with the same overall allocations to equities, bonds and
help investors quantify the diversification benefit they T‐Bills. Chart 1 shows the risk‐reward characteristics for
achieved by adding more investments to their portfolio. these three sets of portfolios.
Hedge fund investors have implemented the The time frame for this analysis was the common time
prescription of diversification in many ways. period of the five Hedgeharbor managers. The
Institutional investors and funds of hedge funds performance for this common time period began in
diversify across asset classes, strategies, geographic March 2008—at the onset of the global financial crisis—
focus, and other dimensions. Such investors often and covers the aftermath of the crisis as well.
attempt to achieve diversification across these
Chart 1: Risk‐Reward Characteristics
dimensions by allocating to 30 or more single hedge
6.0%
funds. But such broad diversification in hedge funds
may not be necessary to reduce the overall risk in a
HH Bundle
portfolio. 5.5%
Compound ROR
Some research suggests that the additional benefits of
HH
diversification declines as the number of hedge fund 5.0% Standard +
managers in a portfolio increases.1 Adding a few HFRI HH
managers can add diversification benefits to a portfolio, Standard
4.5%
but at some point more may not be better.
In order to demonstrate the idea of diversification
4.0%
benefits are achievable even when allocating to
9.0% 10.0% 11.0% 12.0%
relatively few hedge fund managers, we compared the
risk‐reward characteristics for three sets of Standard Deviation
investments. The first was a simple allocation to stocks, During this period, not surprisingly, given the time
bonds and US Treasury Bills. The second portfolio was period covered, an investment in a standard
combination of equities, bonds and US Treasury Bills
produced the highest volatility of the three portfolios.
1
As an example, see How Many Hedge Funds Are Needed to
Adding a 10 percent allocation of the broad hedge fund
Create a Diversified Fund of Funds?, Asset Alliance Corp.,
2002 index reduces the volatility, but contributed negatively

2. to returns during this period. Replacing the broad hedge manager represents only 2.5 percent of the larger
fund index with a 10 percent allocation to the overall portfolio, so even if one manager suffers a large
Hedgeharbor five‐manager bundle, however, both loss or some idiosyncratic risk event, the impact on the
increased returns and lowered volatility. portfolio is manageable.
The key to achieving these diversification benefits of Some smaller institutional investors will still chose to
course is careful manager selection. That means allocate to funds of hedge funds as a means of gaining
devoting resources and effort to identifying and alternative investments exposure. It is by conducting
evaluating the managers that ultimately go into the research and due diligence on a large number of single
investor’s portfolio. manager funds and exhibiting skill in constructing
portfolios of these managers that funds of funds
Performing research and conducting due diligence
provide the greatest benefit to investors. Nevertheless,
reviews on a large number of hedge funds typically
as we have shown here, it is possible for an investor to
requires greater resources than many smaller investors
gain the diversification benefit of hedge funds by
can or are willing to devote to a relatively small
investing directly in a limited number of single
percentage of their overall portfolio. By focusing these
managers.
resources on fewer managers, the investor can achieve
the benefits of such investments at a more reasonable Hedgeharbor stands ready to assist investors in
cost. identifying quality single managers as well as multi‐
manager products that meet their investment goals and
Of course, by being more concentrated in a smaller
objectives.
number of managers, the risk of failure of any one of
them is magnified. However, in this example any one