COMMENTARY

Hedge Fund Manager Diversification

Whats the right number of funds in a portfolio?
CHRISTOPHER M. SCHELLING, DEPUTY CIO, DIRECTOR of ABSOLUTE RETURN, KENTUCKY RETIREMENT SYSTEMS

Fig.1 Impact of hedge fund blow-up

Source: Kentucky Retirement Systems

20%
0%

PORTFOLIO RETURN

nstitutional investors are invariably confronted

with numerous challenges when attempting to
construct a diversified portfolio of hedge funds.
While too abundant to list, some of these challenges
include governance issues, such as cumbersome
and inefficient internal contracting processes for
hiring external managers or various regulatory
requirements, and resource constraints, for example
limited in-house staff and modest administrative
budgets. In addition to these operational
considerations, there are of course direct investment
challenges in hiring hedge funds such as acquiring
or accessing the requisite specialised skills to decide
upon strategy allocations as well as to vet and
select individual managers across areas as diverse as
correlation/dispersion trading or Japanese crossholding activism.

-20%
-40%

F
O

-60%
Scenario 1
Scenario 3
Scenario 5
Scenario 7

-80%
-100%
1

Scenario 2
Scenario 4
Scenario 6
Scenario 8
11

16

21

26

31

36

41

NUMBER OF MANAGERS

O
R

One of the challenges which investors face that

may seem relatively mundane in comparison is
also a highly critical and often overlooked concern:
how many hedge funds in a direct portfolio is the
right number? Of course, there is no one-sizefits-all answer to such a broad question. While
finding the optimal amount of concentration versus
diversification is an investment puzzle that has
confronted practitioners since well prior to the
institutionalisation of the hedge fund industry,1
there are a number of considerations specific to
hedge funds that impact the number of line items an
investor should target.

Outside of the typical issues of asset size of the

intended portfolio, the number of internal staff
supporting the process, access to consultants and
other strategic partners, the risk/return objectives
of the portfolio are perhaps most important in such
a heterogeneous investment arena. For instance,
for a portfolio intended to outperform a broad

hedge fund index such as the HFRI Fund Weighted

Composite (arguably a nave objective), the a
priori motive is to access idiosyncratic risk. Unlike
traditional capital markets, where diversification
is intended to eliminate idiosyncratic risk in favour
of systematic risk (i.e., beta), there should be an
upper bound on diversification within hedge funds,
as increased diversification mathematically reduces
the possibility of idiosyncratic outperformance
(i.e., alpha). To the extent that hedge funds would
be considered expensive active management, an
allocation to hedge funds should be intended to
outperform some less expensive comparable return
stream. If you want to simply be the market in hedge
funds perhaps the capital could be better allocated
elsewhere to begin with.

actual costs with performing due diligence on hedge

funds such as travel expenses, background checks,
legal fees, investment staff man-hours as well as
ongoing resources needed to monitor the portfolio.
Obviously, an investor should only expend these
additional incremental costs if they can reasonably
expect to be compensated for it.
Conversely, a certain minimum number of
managers is needed in order to ensure basic
strategy and underlying asset class diversification.2
Concentration is a double-edged sword which
increases the probability for outperformance as well
as underperformance. Again, unlike liquid capital
markets, volatility may not be the best proxy for risk
in this context. Hedge fund returns are non-normal,
but also investing in limited partnerships requires
foregoing custody and day-to-day oversight of the
actual assets. These are real risks.

Further, selecting too many managers carries several

additional explicit negatives as well. There are

Table 1 Different scenarios when faced with a hedge fund blow-up

DRAWDOWN
Blow-up return
Average return
Number of managers
1

Source: Kentucky Retirement Systems

SCENARIO 1

SCENARIO 2

SCENARIO 3

SCENARIO 4

SCENARIO 5

SCENARIO 6

SCENARIO 7

SCENARIO 8

-50%

-75%

-25%

-90%

-50%

-25%

-90%

-75%

1%

-2%

-1%

-3%

0%

1%

2%

3%

-50.0%

-75.0%

-25.0%

-90.0%

-50.0%

-25.0%

-90.0%

-75.0%

-24.5%

-38.5%

-13.0%

-46.5%

-25.0%

-12.0%

-44.0%

-36.0%

-16.0%

-26.3%

-9.0%

-32.0%

-16.7%

-7.7%

-28.7%

-23.0%

-11.8%

-20.3%

-7.0%

-24.8%

-12.5%

-5.5%

-21.0%

-16.5%

-9.2%

-16.6%

-5.8%

-20.4%

-10.0%

-4.2%

-16.4%

-12.6%

45

-0.1%

-3.6%

-1.5%

-4.9%

-1.1%

0.4%

0.0%

1.3%

46

-0.1%

-3.6%

-1.5%

-4.9%

-1.1%

0.4%

0.0%

1.3%

47

-0.1%

-3.6%

-1.5%

-4.9%

-1.1%

0.4%

0.0%

1.3%

48

-0.1%

-3.5%

-1.5%

-4.8%

-1.0%

0.5%

0.1%

1.4%

49

0.0%

-3.5%

-1.5%

-4.8%

-1.0%

0.5%

0.1%

1.4%

50

0.0%

-3.5%

-1.5%

-4.7%

-1.0%

0.5%

0.2%

1.4%

44

One particular real risk of more (or perhaps less,

as the case may be) concern to institutional
investors which actually materially increases with
each additional manager added to the portfolio
is headline risk, or the probability that one of the
managers in the portfolio appears in the financial
media related to accusations of untoward activity.
The cumulative probability of having such an event
in your portfolio increases with each additional line
item. Taken to the logical extreme, if an investor
becomes the market, every single headline event
in the industry will thus occur in their portfolio.
For institutional investors, such an outcome may
not have an immediate monetary or returns-based
impact on the portfolio, but it often can invite
regulator ire or the erosion of goodwill from their
constituents. Such a perception of weak due
diligence efforts can ultimately alter the governance
structure and investment processes of an
institutional investor, and not always for the better.
Its not a surprise then that steps are often taken to
proactively reduce such adverse consequences.

an additional line item.3 Table 1 summarises the

results.

F
O

As should be obvious in Fig.1, at some point, adding

more and more managers to the portfolio has little
to no effect on reducing the impact of the blow-up
on the portfolio return. Also readily apparent is
the implication that across most scenarios, having
fewer than 10 managers results in the blow-up
significantly impacting the portfolio return. The
slope of the curve for most functions below 10 is
still quite steep, suggesting significant marginal
diversification utility from an additional manager.
In scenario 8 for example (-75% blow-up, average
return of 3%), the portfolio would lose 5% with 10
managers but only 1% with 20 managers. Without
unnecessarily complicating the discussion with
additional formulas, this analysis suggests that
anywhere between 15 and 30 managers may be a
prudent number of line items for typical institutional
investors.

O
R

Undoubtedly, not all headline events are created

equal, and avoiding them should not be the
preeminent concern of building a portfolio. However,
certain headline scenarios can actually result in
catastrophic investment losses, notably operational
blow-ups or outright frauds. Obviously, robust due
diligence and manager selection processes are
intended to prevent such managers from entering
the portfolio in the first place. But to be honest,
one cannot completely eliminate the possibility of
this occurring short of simply not investing in hedge
funds. However, the potential impact of possible
catastrophic losses on the portfolio can be mitigated
through position sizing, which is directly related to
number of positions.
It is thus with the objective of balancing the
outperformance potential of concentration with
the risk mitigation characteristics of diversification
that we conducted a simple sensitivity analysis
investigating the impact of additional managers
to a portfolio of hedge funds which has suffered a
blow-up.
This analysis assumed an individual hedge fund
generated a one-month loss ranging from -25% to
-90%, a fairly broad range that should encompass
all definitions of a blow-up. The other N number of
managers in the portfolio were then assumed to
generate an average rate of return for the period
between -3% and 3%, a range that captures nearly
90% of the historical monthly return distributions
of any hedge fund index. Holding the returns
constant in a given scenario (for instance, a -50%
blow-up return and 1% average return), the number
of managers N was increased to 50, thus isolating
the incremental impact on portfolio return of

such an unfortunate outcome on the overall fund

should it occur. Although the above analysis focused
on equal weighted, or nave diversification, position
sizing paradigms a discussion for another day can
also serve to further reduce portfolio risk. THFJ

Correspondingly, in our customised fund of one

portfolios, KRS has decided to reduce the allowable
number of individual hedge funds to a range of 15
to 35 line items from the previous higher range of
approximately 25 to 55 managers. Additionally,
our investment committee has approved a direct
portfolio target of approximately 20 managers to fill
out over the next two years. While it is absolutely
incumbent upon investment professionals to do
everything possible to ensure that the ex ante
possibility of a significant loss does not accompany
an investment in a hedge fund, prudent portfolio
construction can serve to mitigate the effects of

R EFER ENCES

Elton E., Gruber M. (1977), Risk Reduction and

Portfolio Size: An Analytical Solution, Journal of
Business, (Oct. 1977), 415-437
Lhabitant F.S., Learned M. (2004), Finding the Sweet
Spot of Hedge Fund Diversification, EDHEC White
Paper, (April 2004)
Lhabitant F.S., Learned M. (2002), Hedge Fund
Diversification: How Much is Enough?, FAME
Research Paper, (July 2002), No. 52
Lintner J. (1965), Security Prices, Risk, and Maximal
Gains from Diversification, The Journal of Finance,
20, 587-615
Markowitz H.M. (1959), Portfolio Selection: Efficient
Diversification of Investment, John Wiley & Sons,
New York, YK

A BO UT T HE AU T HO R

CHRISTOPHER M. SCHELLING

Christopher M. Schelling is Deputy CIO, Director

of Absolute Return, Kentucky Retirement Systems
and Adjunct Professor of Finance, Gatton School of
Business, University of Kentucky.

FO OTN OT E S

1. For instance, see Markowitz (1959), Lintner (1965),

or Elton and Gruber (1977). These studies, as well
as a multitude of others, although sometimes
contradictory, have in the aggregate suggested
the optimal number of individual line items in a
portfolio lies somewhere between 8 and 40. Above
this point, idiosyncratic or unsystematic risk is
substantially reduced and additional positions
contribute little incremental portfolio-level
volatility reduction.
2. Research by Lhabitant and Learned [(2002),
(2004)] constructed equally weighted hedge fund
portfolios from N (number of managers) = 1 to 50
by randomly selecting hedge funds from a data set
of nearly 7,000 funds. At each point N, the random
sampling was conducted for 1,000 trials, creating
50,000 portfolios. The authors demonstrated
certain risks such as skewness and volatility were
already reduced by approximately 75% at only five
managers. Marginal diversification benefits were
negligible by 30 to 35. Worse, some risks were
actually shown to have increased with the addition
of new managers, such as correlation to equities
and kurtosis. The authors ultimately concluded that
the optimal number of hedge funds that provided
most of the benefits of diversification without the
added risks of additional managers was roughly 10.
3. For the more algebraically inclined, the formula
was Portfolio Return = [(1/ N) * CBlow-up Return] + [(N
-1)/ N * CAverage Return). Note that as N approaches
infinity, Portfolio Return approaches CAverage Return
asymptotically. The intention was to measure the
rate of flattening of the slope of the function for all
realistic values of CBlow-up Return and CAverage Return.
We omit this additional analysis in the interest of
simplicity.

45