Diversification and Persistence in Hedge Funds

Abstract

We examine the current fund of hedge funds universe, and find that funds of hedge funds report holding between 1 and 200 underlying funds, and generally hold 10-30, with close to 20 on average. We regress the performance of this universe on the number of holdings and find that return is practically orthogonal to the number of underlying hedge funds held. However, when we regress risk-adjusted return measured by the ex post Sharpe ratios of funds-of-hedge funds, we do find a statistically significant positive relation over 5-year periods; this seems consistent with our findings that diversification reduces volatility. We also examine the diversification effect on total risk reduction in a variety of hedge fund strategies, and we report the total risk as a function of the number of underlying hedge funds for four strategies: Equity Long/Short, Arbitrage, Event-Driven and Distressed, and Global Macro. We find that the asymptotic level of total intra-strategy systematic risk varies across the strategies, from about 3% to about 10% annualized standard deviation, while diversification across funds within each strategy reduces total portfolio annualized standard deviation by about 40% - 50%, at 15 to 25 holdings. Finally, we examine whether there is persistence in the risks and returns of hedge funds, and find persistence in returns at up to 2-year horizons and strong persistence in total risk at up to 4 year horizons.