Hedge Fund Diversification

Since hedge funds often have concentrated and unique risk exposures, diversification is especially important. Furthermore, since hedge funds usually require a large commitment, an investor should make sure there is some diversification to counter the risk associated with that large investment.

As mentioned, hedge funds usually require a large investment. Hedge funds often require an initial investment of $1 million or more, for example, and some require several million dollars. To achieve a diversified hedge fund portfolio, an investor would have to make several such investments. The necessary capital to achieve diversification could easily be in the tens of millions of dollars. Such an allocation to hedge funds would require the total portfolio of all assets to be many times as large, and relatively few investors have portfolios of that size.

However, simply investing in several funds may not be sufficient to achieve diversification. The investor needs to make sure the risks of the funds in which he invests are different enough to provide diversification, and this can require costly due diligence on the part of the investor. The due diligence is required because of the lack of transparency in the hedge fund industry. Although hedge fund managers may reveal information to recruit investors, they do not have to do so, and the due diligence will take time and money.

The due diligence process can take time because the potential investor should meet with the manager and have a follow-up meeting. The potential investor might hire an investigative firm. It is possible for a prospective investor to spend tens of thousands of dollars to learn about the fund. This could include hiring a third party to do research on the firm.

In order to diversify, hedge fund investors can choose to invest in a fund-of-funds hedge fund, which is essentially an investment in several different hedge funds. The manager of the fund-of-funds monitors the individual hedge fund investments. The manager of the fund-of-funds simultaneously provides investors with a diversified portfolio of hedge funds, as well as risk management services. Recent data has indicated that funds-of-funds manage 30% or more of individual hedge funds. This is evidence that hedge fund investors find them useful.

Hedge funds often take positions that have a low correlation with the entire market. One reason for this is that hedge fund managers do not focus on a market benchmark. The managers focus on absolute return. On average, hedge funds maintained their value during the decline in stock values associated with the collapse of Internet stocks in 2000. Such low correlation, especially in the face of a large negative market move, offers excellent diversification. However, the evidence suggests that hedge funds are increasingly becoming correlated with overall market moves. Thus, the diversification benefits may be on the decline.

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