Hedge Funds Diversification

RISK MANAGEMENT FOR INVESTORS

RISK MARCH 2002

WWW.RISK.NET Hedge funds This article analyses the benefits of hedge fund diversification and the efficiency of a fund of funds in capturing these benefits. We first explore whether hedge funds, as a group, represent a set of risks and returns that are statistically independent of and uncorrelated to the equity market. Next, we look at style categorisations of hedge funds and the related style indexes to determine if they represent a meaningful framework around which to effectively manage diversification within a portfolio of hedge funds. Finally, given this context, do funds of funds provide greater value than a diversified portfolio of hedge funds?

The power of diversification Diversification is a valuable part of achieving superior, risk-adjusted returns. For example, if a fund investment has a history of 12% annual returns and a 10% annualised standard deviation, the fund would have a Sharpe ratio – [very brief explanation] – of 0.7 (assuming a 5% riskfree rate). If an investment of equivalent size is made in a second fund with a similar performance history, and the second fund was 100% correlated with the first fund, the portfolio of the two funds would also have a Sharpe ratio of 0.7 (see table A, case 1).

However, if the performance of the two funds were uncorrelated – statistically independent – the standard deviation of a portfolio comprised of the two funds would decline to 7.1% compared with 10% for each of the individual funds. In addition, the resulting Sharpe ratio of the portfolio would be a far superior 1.0 (see table A, case 2). Alternatively, if the performance of the two funds were again uncorrelated, an investor could select a second fund with an annual performance of only 8% and still achieve the same 0.7 Sharpe ratio (see table A, case 3) that they achieved by selecting a perfectly correlated fund with an annual performance of 12%. Diversification is so valuable that one can sacrifice 33% in performance – 8% versus 12% – and achieve an equivalent riskadjusted return.
The characteristics of the first fund – 12% annual performance and 10% volatility – are similar to that of the S&P 500 over a long period of time. Most investors have a significant exposure to the US equity market. Therefore, the logic presented above is valid for an investor who already has S&P 500 exposure and seeks to invest in a hedge fund. The investor with equity exposure should be indifferent between investing in a hedge fund that is highly correlated to the S&P 500 and that will generate a 12% annual return, and investing in a hedge fund that is non-correlated and will generate an 8% annual return.

A valuable diversification? Most investors have significant exposure to the equity markets through traditional, long-only managers. Investing in alternative investments can provide risk diversification for an investment portfolio. Portfolios have the potential for exposure to three different types of risks.

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