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Wednesday, October 29, 2008

Jack of All Trades?

We are brought up with the mantra that, while substantially limiting the upside, diversification saves us on the downside. Being by nature (partly subconsciously) risk-averse we tend to diversify endlessly, protecting against losing our dinner, even if it means a lesser chance of a royal dinner with the Queen.

Possibly true for the individual - not necessarily for the managed funds. Let's dig deeper...

Our investigations into recent hedge fund performance bring us back to our deliberations on whether diversification really is always such a good thing. (Remember, the monolines, in an attempt to diversify their portfolios, moved away from being purely muni-bond insurers, and were stung by their participation in the structured finance market. See Muni Bond Insurance (for the short term) for more on this.)

This chart (click on it to enlarge) shows us that multi-strategy hedge funds are among the worst performing in the down cycle.


Some thoughts and possible explanations/justifications:
(1) Multi-strategy funds tend to be more highly leveraged on the back of this diversification (just like certain ABS, CDOs)
(2) As you have more strategies under management, you may tend to lose asset-specific expertise
(3) Perhaps better managers like to keep it clean and simple...

Summary opinion: perhaps diversification is truly a good thing if it's not mis-used or mis-applied. If the diversified fund or portfolio is able to be more aggressively managed purely due to the benefits of diversification, the plain vanilla option, often cheaper, may just become more enticing.

5 comments:

Anonymous said...

Heavy leverage has likely played a heavier role than other factors in the failure of multi-strategy funds to outperform their benchmarks.

Multi-strategy funds may have provided absolute returns and diversification in a period of plentiful and cheap financing, however the contraction in credit has caused correlation to approach 1 across every asset class.

The downshifting in leverage has been a slow and painful process. The first cracks appeared as major broker-dealers, under balance sheet constraints did not continue to provide previously available financing.

Under financing pressure, multi-strategy funds sold well performing, liquid assets in order to support under-performing, illiquid assets.

This avoided "realizing" losses, and lowered overall leverage - however it also reduced allocations to liquid strategies and increased exposure to illiquid assets. As credit disappeared, more assets became illiquid, affecting overall returns.

"Diversification" therefore, will not function properly if risk is not adjusted to reflect the market, but instead becomes a function of financing.

Anonymous said...

Well…diversifying just for the sake of diversifying doesn’t really accomplish anything unless you dig deeper and understand what you are diversifying into. For example buying a “diversified” MBS deal will supposedly reduce your credit risk from defaulting homeowners since you have homes underlying the deal from all over the country and home prices never go down everywhere at the same time!!!

A good point in there is that the Multi-Strategy funds were probably more levered…since they had “so little risk through diversification” they probably felt they could easily bring up their leverage.

However, I would also think that many of the Multi-Strategy funds weren’t as diversified as people think…either by being heavily focused on one strategy or unknowingly having the same bet on through many instruments.

Barry Ritholtz said...

Nice!

See if this sends you any traffic:
http://www.ritholtz.com/blog/2008/11/hedge-fund-performance-by-strategy/

Kevin said...

Bogus to compare these returns to a stock index - most of these strategies aren't pure stocks.

Anonymous said...

Kevin I'm betting that's not a stock index - it's the index of hedge funds