Intelligent Hedge Fund Investing
Successfully Avoiding Pitfalls through Better Risk Evaluation
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Leola B. Ross


Ross focuses on a problem unique to a large (institutional) investor who wishes to allocate risk to hedge funds. For such an investor, the absolute size of the investment is large for the targeted hedge funds, even if it represents a small fraction of the investor’s portfolio.

The act of allocating large sums pose risks, if hedge funds have limited capacity in generating alpha. Groucho Marx is supposed to have said, I don't want to belong to any club that will accept me as a member. Ross asks, should an investor be leery of the fund that is willing to put large sums to work?

To address this question, she examines the relationship between assets under management (“AUM”) and hedge fund returns.

She finds that small funds seem to perform better, supporting the hypothesis that there are limits to scale. However she also finds that in the short term, increases in AUM improve performance.

She also finds evidence that there is more at work here than just size, because the very largest funds do not seem to suffer from the same capacity problems associated with other funds.

To the extent that her results suggest that a large investor does not shower it’s largesse on a single fund, she asks, how many funds makes a diversified portfolio of hedge fund investments. She finds that diversification can be attained with relatively few funds, perhaps 25 or fewer.

And she finds that the benefit of diversification does not dissipate as the number of funds held in the portfolio increases. This is an interesting result to reconcile with another observation made by other authors, namely that portfolios of hedges funds (or more specifically hedge fund indexes) display low diversification benefit to tail events.

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  1. Brown, S.J., W.N. Goetzmann, and R.G. Ibbotson, 1999, “Offshore Hedge Funds: Survival and Performance 1989–95,” Journal of Business 72(1), 91-117.
  2. Christopherson, J., Z. Ding, and P. Greenwood, 2001, “The Perils of Success: The Impact of Asset Growth on Small-Capitalization Investment Manager Performance,” Russell Research Commentary (July).
  3. Clow, R., 2001, “Global Investing—Demand for Hedge Funds of Funds Looks set to Increase,” Financial Times (October 11): 31.
  4. Denmark, F., 2000, “Hedge Funds: An Industry Coming of Age,” Bloomberg Wealth Manager, (March), 41.
  5. Fung, W. and D. Hsieh, 2002, “Hedge-Fund Benchmarks: Information Content and Biases,” Financial Analysts Journal 58, 1.
  6. Gopalan, S., 2001, “Strong Growth Forecast for Fund of Funds Industry,”
  7. Greenwood, P., 1999, “The Evolution of Investment Processes,” Russell Research Commentary (June).
  8. Gregoriou, G. N., and R Fabrice, 2002, “Large versus Small Hedge Funds: Does Size Affect Performance?” Journal of Alternative Investments (Winter), 75–77.
  9. Hennessee, L.E., and C.J. Gradante, 2002, “Direct Investing in Hedge Fund versus Fund of Hedge Funds Products,” Hedge Fund Strategies: A Global Outlook. Institutional Investor Investment Guides, edited by B. R. Bruce, 118–123.
  10. Ineichen, A. M., 2001, “The Search for Alpha Continues: Do Fund of Hedge Fund Managers Add Value?” Global Equity Research. UBS Warburg (September).
  11. Lins, G.T., 2002, “Hedge Fund Organization,” Hedge Fund Strategies: A Global Outlook. Institutional Investor Investment Guides, edited by B. R. Bruce, 98-102.
  12. Mikdashi, R., 2002, “Hedge Funds Grapple with Capacity but Market Senn Open for Growth,” Alternative Investment News, 3 (March), 1.
  13. Patel, S.A., B. Krishnan, and J. Meziani, 2002, “Addressing Risks in Hedge Fund Investments,” Hedge Fund Strategies: A Global Outlook, Institutional Investor Investment Guides, edited by Brian R. Bruce: 89–97.
  14. Ross, L. B., 2002, “Hedge Fund Diversification: How Much is Enough, and Where Does One Start?” Russell Consulting Practice Note #52. Frank Russell Company (December).
  15. Ross, L. B., 2002.,“Risk Exposures and Hedge Funds,” Russell Research Commentary (November).
  16. Ross, L.B and G. Oberhofer, 2002, “What the ‘Indexes’ Don’t Tell You about Hedge Funds,” Russell Research Commentary (May).
  17. Stemme, K., and P. Slattery, 2002, “Hedge Fund Investments: Do It Yourself or Hire a Contractor?” Hedge Fund Strategies: A Global Outlook. Institutional Investor Investment Guides, edited by B. R. Bruce, 60-68.
  18. VAN Hedge Fund Advisors International, “Quantitative Analysis of Hedge Fund Returns /Risk Characteristics.”

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Table of Contents


"How exciting to read a book that is so timely and practical"
Tanya Styblo Beder, CEO, Tribeca Investments

Publisher: Risk Books
Hardcover: 470 pages
ISBN: 19044339220

Editor: Barry Schachter
(US$ 153.00)
(GBP 85.00)

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© 2004 Barry Schachter