Is it really “diworsification”?

Some prominent voices have maintained that there is a point in a hedge fund portfolio, where additional diversification turns from an improvement of the risk/return characteristics into a worsening. Francois-Serge Lhabitant recently referred to this process as “diworsification”.

There is no consensus as to what the optimal number of funds in a diversified fund of hedge funds should be, but those who argue that over-diversification leads to “diworsification” usually use10 to 40 hedge funds as the appropriate number.

The three main arguments often used for limiting the number of hedge funds in a portfolio:

1. The volatility (or risk) of a hedge funds portfolio cannot be reduced substantially if you add more managers above a certain number.

    

2. There are only a few skilled managers, who really are able to provide alpha. Adding additional managers increases the likelihood of a decrease of alpha at the portfolio level.

    

3. The additional cost for due diligence are higher than the added value.

    

In contrast Primores’ approach is to create portfolios consisting of 200 to 300 underlying hedge fund managers. The question arises if we are end up with “diworsified” portfolios in neglectingthe above arguments….

Primores’ view regarding the three arguments (which are mainly backed by academics, originally based on traditional portfolios) differs in the following ways:

1.       We agree that adding further hedge funds above a certain point has limited impact in reducing the portfolio’s volatility. But we think that volatility is not taking into account all aspects of hedge fund risk.

The limitation with volatility as a measure is that it is not suitable in extreme situations. Such situations could either be hedge fund specific, as we saw this summer with MotherRock or Amaranth. Or market specific, as during the liquidity crisis in 1998.

Our aim at Primores is create portfolios with very broad diversification that will not only reduce volatility but, more importantly, will limit maximum drawdown in extreme situations. Here’ssimple illustration of the benefits derived from broad diversification in limiting drawdown in a portfolio: compare a portfolio consisting of 20 hedge funds with one consisting of 200 hedge funds. Ifyou are affected by a total loss in one hedge fund (and as we know, this happened even to the biggest and brightest funds of hedge funds managers with Amaranth and will happen in the future again)the loss in the first case is 5%, in the second case 0.5% (assuming equal weighted portfolios).

2.      The next argument would then lead to the conclusion that you are not able to find 200 skilled managers, delivering a positive alpha. We at Primores do not believethat out of about 10’000 hedge fund manager there are only 20 or 50 good ones. There must be many more. Or otherwise you would have to conclude that most investors are incompetent and misguided,selecting and investing in the rest of the universe (9950 hedge funds). Obviously there is a lot of talent in the universe but the challenge becomes selection or separating the wheat from the chaff.

In our view it’s more a question of specialist know-how. One has to understand the 10’000 different strategies the 10’000 hedge fund managers offer. We are certainly no capable of understandingall these strategies and much less able to judge the quality of the manager who will be executing the specific strategy. As a result we have chosen to work with truly specialised funds of hedge fundsmanagers, who concentrate just on a small part of the universe. The part they understand.

3.      Have a look at the presentations of funds of hedge funds. Most of them claim to screen the “entire” universe. The funnel chart is prominently displayed informingus that, due to rigorous due diligence they reduced the universe to the 10-40 selected managers. The implication is that each fund of hedge funds has the resources to be able to scan and select fromthe entire universe.

At Primores our approach results in very broadly diversified and robust portfolios with limited single manager risk. At the same time performance is not sacrificed and our total costs are no higher than those of competing fund of hedge funds.

Bottom line: neither academic studies nor marketing presentations; only net of fee performance really can prove if a concept is superior.

Our conviction is that our approach will serve our investors well over a long period of time.

Primores AG

Gotthardstrasse 54

P.O. Box 2022

CH-8027 Zurich

Wenzel Müller, CAIA

Investment Solutions & Advisory

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