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Faculty & Research


Diversification Benefits of Funds of Hedge Funds: Identifying the Optimal Number of Hedge Funds

Journal Article
This article introduces a new analytic framework to assess the risk/return profile of hedge funds and funds of hedge funds. As alternatives to the traditional time-series mean and standard deviation, the cross-sectional average and dispersion of the terminal wealth accumulated from an investment in baskets of hedge funds are used here. The end-of-period wealth approach circumvents well-known statistical biases marring parametric time-series analysis, especially the under-estimation of risk. Simulations performed in this article indicate that the risk of single hedge funds is much higher within a terminal wealth framework as compared to the traditional framework. However, this higher risk exposure can be channeled by investing in funds of hedge funds, the diversification benefits of which are found to be substantial. In addition, a small number of funds are necessary to diversify risk away. The terminal wealth framework should be particularly relevant for investors with fixed investment horizons and predefined liabilities to meet, such as pension funds and insurance companies.

Professor of Finance