Abstract: Hedge fund strategies are not as unique as investors believe. We examine 18 strategy indexes and find that three factors capture more than 87% of the variation in returns. Most strategies are redundant, which has several implications for portfolio construction. Investors should focus on finding quality funds independent of strategy.
Diversification is powerful. Most investors understand that it can substantially improve portfolio performance. Too much diversification can be just as detrimental as too little, however, if it causes investors to diversify into less attractive investments.
Benartzi and Thaler (2001)1 found that investors in defined contribution plans tend to divide their assets equally among available options, even when doing so results in poor asset allocations. Institutional investors, although usually much more sophisticated than retail investors, often make a similar mistake by over-diversifying into a wide array of asset classes and investment strategies.
It makes sense for institutional portfolios to include each of the most common hedge fund strategies if each contributes something unique, but is this really the case? In this report, we analyze hedge fund indexes using four different tools—correlation, clustering, principal components, and optimization—to determine which strategies are, in fact, distinct.