Diversification: Prudent investing dictates that portfolios should be well diversified. Some investors lack the necessary asset size and expertise to invest directly in hedge funds to reach an appropriate level of diversification and risk reduction. By contrast, through a single FoF investment, investors can access a well-diversified portfolio in terms of managers or strategies.

However, the diversification level of an FoF portfolio is not necessarily a straightforward function of the number of underlying funds or strategies. This is because hedge funds are not single securities. Instead, they are already-diversified portfolios of securities.

Numerous researchers have studied the impact of increasing the number of funds in an FoF portfolio on various risk measures using a naïve diversification approach (i.e., random selection and equal weighting of the underlying managers). For a single-strategy FoF,1 an equally weighted portfolio consisting of approximately three to five hedge funds is usually highly correlated with its respective hedge fund strategy index. Moreover, such a portfolio reduces the overall strategy-specific portfolio risk to the level of the universe from which the funds are drawn. This clearly supports the idea, say researchers, of running relatively concentrated single-strategy FoFs. The same has been found to be true for multistrategy FoFs. Lhabitant and Learned (2003, 2004) suggest that an equally weighted portfolio of ...

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