Fund of Funds
Diversification:
How Much is Enough?
Downloaded from https://jai.pm-research.com by Flavio Ferreira on March 5, 2020 Copyright 1998 Pageant Media Ltd.
JAMES M. PARK AND JEREMY
A
JAMES M. PARK lthough considerable research
is a professor of
in the alternative investment
finance at Long Island
area concentrates on the per-
University College of
Management and formance characteristics of in-
Chairman and CEO of dividual hedge funds or commodity trad-
PARADIGM Capital ing advisors ŽCTAs. Že.g. Fung and Hsieh
Management in w 1997a, 1997bx. , many investors hold a
New York.
portfolio of alternative investment man-
JEREMY C. STAUM agers. For traditional investments, the rule
is a Ph.D. candidate at of thumb that nearly all of the diversifi-
Columbia Business able risk is eliminated in a portfolio of ten
School and Director of stocks dates back to Evans and Archer
Research PARADIGM
w 1968x . Evans and Archer discussed the
Capital Management
in New York. mathematical relationship between the size
and variance of a portfolio and showed
that for an equally weighted portfolio each
randomly selected security added to the
portfolio produces an ever smaller de-
crease in portfolio variance. The actual
impact of random security diversification
for stock and bond portfolios has been
analyzed by various authors. Both Elton
and Gruber w 1977x and Hill and Schneeweis
w 1980x illustrated the impact of random
security selection on portfolio variance for
stocks and bonds, respectively. In both
cases, the final impact is determined by
the intrasample correlations. For instance,
Hill and Schneeweis show that for portfo-
lios of AAA bonds, the high intracorrela-
tion of AAA rated bonds, in contrast to
BAA rated bonds, lessens the impact of
WINTER 1998
C. STAUM
diversification on portfolio variance. Hill
and Schneeweis also showed that as secu-
rities are added, the tracking error Ž the
difference of the randomly selected port-
folio’s variance from its expected vari-
ance. decreases.1 As such, investors must
realize that not only does diversification
reduce portfolio variance, it also increases
accuracy in achieving the expected level
of risk.2
RANDOM DIVERSIFICATION
FOR MANAGED FUNDS
Results for portfolios of managed
futures and hedge funds are similar to
those illustrated in previous studies on
stock and bond diversification. Billingsley
and Chance w 1996x have shown that naive
diversification among as few as ten CTA
managers results in a mixed stock
Žstock兾bond. and CTA portfolio resulting,
on average, in a lower asymptotic portfo-
lio variance. The benefit of adding CTAs
to the traditional passive stock and bond
portfolio comes from the low correlation
between the CTAs and the traditional in-
vestment vehicles.
The number of CTAs required to
achieve the lower variance bound for the
mixed traditional and nontraditional port-
THE JOURNAL OF ALTERNATIVE INVESTMENTS 39
 folio is, as for stocks or bonds, determined by the
correlation among the represented sample CTAs.
The more similar the styles and markets traded, the
lower the impact of the increased number of CTAs
on reducing the portfolio variance. For stand-alone
alternative investment portfolios, Henker and Martin
w 1998x showed that the higher the intracorrelation
Downloaded from https://jai.pm-research.com by Flavio Ferreira on March 5, 2020 Copyright 1998 Pageant Media Ltd.
where ␴ 12 is the expected variance of a single
randomly selected security, ␴ M2 is the variance of
the market portfolio of securities, and ␴n2 is the
expected variance of a randomly selected portfolio
of n securities.5
Equation Ž1. shows how the expected variance
of a portfolio of n randomly selected securities de-

among CTAs in a universe, the lower the number of
CTAs required to achieve the lower variance bound
as well as to mimic the underlying universe’s perfor-
mance benchmark.3 Last, research has shown the
potential benefits of CTA investment in enlarging
the efficient frontier when considered as part of a
mixed stock and bond portfolio Ž Edwards and Park
w 1996x. .
Although original research on the benefits of
naive diversification concentrated on the absolute
reduction in portfolio risk and the ability of the
portfolio to track that of the underlying universe of
benchmark, more recent research Ž Statman w 1987x.
concluded that investors should perform a marginal
cost兾benefit analysis in terms of a common
return兾risk ratio to determine an appropriate num-
ber of securities to hold. In practice, there is no
widely used method for computing this number, but
Statman showed that many investors’ diversification
policies, which often result in portfolios of fewer
than ten assets, appear to be suboptimal in terms of
the tradeoff between reducing variance and the ac-
tual return兾risk performance.
FUND OF FUNDS DIVERSIFICATION
pends on only two empirically estimated quantities,
␴ 1 and ␴ M . In all cases, a portfolio of size 5
eliminates 80% Ž1 y 1兾5. of the diversifiable vari-
ance, whereas a portfolio of size 20 eliminates 95%
Ž1 y 1兾20. of the diversifiable variance. However, ␴ 1
and ␴ M must be estimated for each class of securi-
ties. The greater the ratio of the diversifiable risk
Ž ␴ 12 y ␴ M2 . to nondiversifiable risk ␴ M2 , the greater
the benefits of diversification.
ILLUSTRATION OF
DIVERSIFICATION BENEFITS
A comparison of several asset classes illus-
trates the benefits of diversification across CTAs and
hedge funds relative to typical stock diversification.
The data for 948 CTAs and 1230 hedge funds comes
from the TASS data base for the years 1989 through
1996, and incorporates a correction for survivorship
bias discussed in Park w 1995x . The data for NYSE
stocks comes from Elton and Gruber w 1995x . Exhibits
1 and 2 show that increasing the size of the portfolio
from five to twenty decreases the expected portfolio

In particular, one may address the question of EXHIBIT 1

how many funds belong in a fund of funds. In
Volatility Versus Portfolio Size
practice, has the fund of funds industry attained an
acceptable level of diversification? TASS Manage-
ment, a London-based information services firm
monitoring CTAs and hedge funds, provides an in-
dustry average. Funds of funds contain a mean of
fewer than five funds, and a median of four.4 How
good is the amount of diversification provided by
five funds? Given a simple assumption that all securi-
ties have the same correlation with each other, sta-
tistical theory yields a simple relationship between
portfolio size and variance:

␴n2 s ␴ M2 q Ž ␴ 12 y ␴ M2 . 兾n Ž 1.

40 FUND OF FUNDS DIVERSIFICATION: HOW MUCH IS ENOUGH? WINTER 1998

 EXHIBIT 2
Reduction in Risk through Diversification

Asset Nondiversifiable Diversifiable Reduction

Class Std. Deviation Std. Deviation ␴1 ␴5 ␴ 20 in Risk (%)
CTAs 3.57 3.34 6.91 4.44 3.81 14.33
Hedge Funds 2.05 2.42 4.47 2.71 2.24 17.59
Downloaded from https://jai.pm-research.com by Flavio Ferreira on March 5, 2020 Copyright 1998 Pageant Media Ltd.

NYSE Stocks 2.66 4.17 6.83 3.87 3.01 22.31

Data for stocks are presented for purposes of comparison.

standard deviation by differing proportions for CTAs,
hedge funds, and NYSE stocks. The greatest im-
provement is for stocks; the least is for CTAs. All
show a substantial reduction in risk Ž 1 y ␴ 20兾␴5 ..
Statman w 1987x suggested a method for assign-
ing a value to this reduction in risk. Suppose that an
average fund of funds manager has investments in
five randomly selected CTAs and feels that he has
achieved an acceptable level of risk at 4.44% monthly
standard deviation. As an average fund of CTAs
manager, he has accumulated historical returns over
1989 through 1996 of 12.81%. How much better
could he have done by investing in twenty randomly
selected CTAs while leveraging his investment up to
4.44% standard deviation? Increasing standard devia-
tion from 3.81% to 4.44% allows the manager a
leverage factor of 1.17 Ž 4.44兾3.81. . This results in
annual returns of 15.09%, or a gain of 2.28% per
annum, over his actual strategy. Exhibit 3 summa-
rizes the results for CTAs, hedge funds, and stocks.
CONCLUSION
In the case of stock investors who lend or
borrow, Statman presented this method with the
profits from leverage reduced by the risk-free or
call-money rates, respectively. This reduces the
leveraged stock return from what would have been
22.61% without interest costs. Although leveraging
hedge funds requires borrowing, free leverage is
generally available for CTAs up to 4 or 5:1. ŽThe
only part of a CTAs’ return that may not be lever-
aged is interest income on margin account balances,
which is typically only a small part of the overall
return.. This means that, for instance, it is possible
without borrowing to leverage 2:1 a fund whose

EXHIBIT 3
Gains from Diversifying and Leveraging

Asset Annual Interest Leveraged Gain in

Class Return Leverage Rate (%) Return Return
CTAs 12.81 1.17 0 15.09 2.28
Hedge Funds 12.83 1.21 0 15.76 2.93
Stocks ŽLend. 17.20 1.29 5 20.70 3.50
Stocks ŽBorrow. 17.20 1.29 7 20.12 2.93

In a lending portfolio Ži.e., which includes cash., leverage requires a reduction in lending and
foregone interest at the risk-free rate, 5%. In a borrowing portfolio, leverage requires further
borrowing at the call-money rate, 7%. Figures have been rounded.

WINTER 1998 THE JOURNAL OF ALTERNATIVE INVESTMENTS 41

 5
notional allocations are one-third to hedge funds and For a full discussion of the impact of random
two-thirds to CTAs, by leveraging the CTAs 4:1. security selection on portfolio variance, see Elton and
In the absence of borrowing costs for lever- Gruber w 1977x .
age, the only barrier to diversification is the ability
to make the minimum investment in each fund.
REFERENCES
Management expense for a fund of five funds should
be roughly the same as for a fund of twenty funds.
Downloaded from https://jai.pm-research.com by Flavio Ferreira on March 5, 2020 Copyright 1998 Pageant Media Ltd.

Moreover, the argument that ‘‘overdiversification’’
can lead to ‘‘diversifying returns away’’ is erroneous.
If adding another money manager to a fund really
dilutes its returns, this fund’s managers must have
greater expected return than all other managers.
Obviously, this cannot be simultaneously true for
every fund’s selections. The theory of naive diversifi-
cation is based on the assumption that the typical
portfolio manager is naive in the sense of not know-
ing which money managers are the best, and must
pick randomly. There is almost no cost to increasing
the size of a fund of funds from five Ž the industry
average. to twenty. Because the penalty for inade-
quate diversification is, in effect, foregone profits, it
seems that funds of funds may wish to embrace
diversification more fully.
ENDNOTES
1
See Statman w 1987x for a similar analysis of ran-
dom equity selection.
2
Note that the impact of naive security selection
on portfolio performance concentrates on risk. The
central limit theorem of statistics shows that sample
size affects the sample mean’s variance, but not its
expectation.
3
It is important to point out that an assumption
underlying naive Žrandom. asset selection is that asset
weights are equal, not optimized after selection. For
planned asset diversification based on traditional
mean兾variance optimization, research has shown the po-
tential benefits of CTA investment in enlarging the effi-
cient frontier when considered as part of a mixed stock
and bond portfolio. See Schneeweis w 1998x .
4
The TASS data base is not a random sample of
the universe of funds. Moreover, the low 24% response
rate to this question raises some doubts as to the accuracy
of this number. Nonetheless, in the absence of obvious
biases leading to underresponse by funds with large num-
bers of submanagers, it seems safe to claim that the
average is not much more than five funds.
Billingsley, T., and D. Chance. ‘‘Benefits and Limitations
of Diversification among Commodity Trading Advisors.’’
Journal of Portfolio Management, Fall Ž1996., pp. 65᎐80.
Edwards, F., and J. Park. ‘‘Do Managed Futures Make
Good Investments?’’ Journal of Futures Markets, 16 Ž1996.,
pp. 475᎐517.
Elton, E.J., and M.J. Gruber. ‘‘Risk Reduction and Portfo-
lio Size: An Analytical Solution.’’ Journal of Business, 50
Ž1977., pp. 415᎐437.
ᎏᎏ. Modern Portfolio Theory and Investment Analysis, 5th
edition. New York: Wiley, 1995, p. 61.
Evans, J.L., and S.H. Archer. ‘‘Diversification and the
Reduction of Dispersion: An Empirical Analysis.’’ Journal
of Finance, 23 Ž1968., pp. 761᎐767.
Fung, W., and D. Hsieh. ‘‘Empirical Characteristics of
Dynamic Trading Strategies: The Case of Hedge Funds.’’
Review of Financial Studies, Summer Ž1997., pp. 275᎐302.
ᎏᎏ. ‘‘Survivorship Bias and Investment Style in the
Returns of CTAs.’’ Journal of Portfolio Management, Fall
Ž1997., pp. 30᎐41.
Henker, T., and G. Martin. ‘‘Naive Diversification for
Managed Futures.’’ Working paper, CISDM兾SOM, Uni-
versity of Massachusetts, 1998.
Hill, J., and T. Schneeweis. ‘‘Diversification and Portfolio
Size for Fixed Income Securities.’’ Journal of Economics and
Business, Winter Ž1980., pp. 115᎐121.
Park, J.M. Managed Futures as an Investment Class Asset. Ann
Arbor: UMI Dissertation Services, 1995.
Statman, M. ‘‘How Many Stocks Make a Diversified
Portfolio?’’ Journal of Financial and Quantitative Analysis, 22
Ž1987., pp. 353᎐363.

42 FUND OF FUNDS DIVERSIFICATION: HOW MUCH IS ENOUGH? WINTER 1998