Diversification in the Hedge Fund Industry

Abstract

We provide evidence for a significant relation between diversification and performance in the hedge fund industry. Measuring diversification across four distinct dimensions, we find a significant positive relation between hedge fund performance and diversification across sectors and asset classes. We show that on a risk adjusted basis, hedge funds that diversify across sectors and asset classes outperform other funds by an average of 1.6 percent per year. However, diversification across styles - the “jack of all trades” fund manager - is found to exhibit a significant negative association with hedge fund returns. Diversification across geographies does not have a significant impact on hedge fund performance. For fund of hedge funds, we find a significant positive relation between performance and diversification across sectors, styles and geographies. Furthermore, we find that the motive to engage in diversification is consistent with managerial incentive structure in the hedge fund industry.