THREADING A ROPE THROUGH A NEEDLE: HOW DOES A LARGE-SCALE INVESTOR APPROACH HEDGE FUNDS?
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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ERRATA AND OTHER MATERIAL
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