Funds of funds with more than 20 underlying managers are more exposed to tail risk
EVER since the financial crisis, the fund of hedge funds model has been under fire.
Such firms, which sell baskets of hedge funds to investors, charge too much, investors have complained.
And the investments, said to offer diversification, did little to buffer the market losses of 2008.
Now, it appears, that diversification could actually put them at more risk, according to a forthcoming study.
Not only do funds of funds with more than 20 underlying managers begin to lose the benefit of diversification, they are also more exposed to tail risk events (or highly unlikely, devastating occurrences), according to the study, led by Stephen Brown, a finance professor at New York University's Stern School of Business.
They "may believe that excess diversification reduces tail risk exposure, but the data suggests that tail risk increases with the degree of diversification," according to the study, which has been accepted for publication by the Review of Asset Pricing Studies.
The reason, in part, is because when a fund of funds has a large number of underlying managers; it begins to track indexes more broadly in extreme event situations. While, hedge funds in normal times do not necessarily track the market, extreme events often increase correlations. When they are aggregated, that risk exposure is concentrated, Brown said. Nearly half of the 3,767 funds of funds studied for the paper have more than 20 funds.
The focus in the industry has been misplaced. What is the sweet spot, the optimal diversification? That's the wrong question.
The right one is what's the appropriate amount of diversification for the amount of assets under management.
