The diversification benefits of hedge funds and funds of hedge funds

Abstract

We examine whether investors can improve their investment opportunity set through the addition of a hedge fund (HF) or fund of HF portfolio to different sets of benchmark portfolios. Using data from 1994 to 2004, we find that HF, as an asset class, improve the mean–variance frontier of sets of benchmark portfolios sorted by firm size and book-to-market ratio. However, we find that the improvement comes mainly from a leftward shift of the global minimum-variance portfolio rather than the tangency portfolio. Furthermore, investors who already hold a diversified portfolio do not improve their investment opportunity set by adding HF portfolios. On the other hand, we find that investing in funds of HF, as an asset class, does bring diversification benefits for mean–variance investors, even when we enlarge our investment opportunity set by including fixed income, international assets and commodities.Derivatives Use, Trading & Regulation (2007) 12, 290–300. doi:10.1057/palgrave.dutr.1850053 [ABSTRACT FROM AUTHOR]