While hedge funds-of-funds tout their diversification as a limit on risk, this is not the case, according to research by NYU Stern Finance Professor Stephen Brown and co-authors Greg Gregoriou and Razvan Pascalau of SUNY College at Plattsburgh School of Business and Economics. In extreme market conditions, the professors attest, a broadly diversified hedge fund-of-fund is actually more sensitive to risk than an average hedge fund.

“Those who market funds-of-hedge-funds promote the ability to overcome tail risk exposure by extensively diversifying their hedge fund portfolios,” Brown said. “This is a fantasy. These funds are not an insurance policy against market tail risk.”

The researchers studied a database of 3,767 hedge funds-of-funds and found that once a fund holds more than 20 underlying hedge funds, the benefits of diversification diminish because of common overlap.

The professors also found that the more diversified the hedge fund-of-fund, the lower its return due to the higher cost of due diligence to monitor all of the funds.

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