A few recent articles got me thinking about diversity vs diversification:
· June 5 - Forbes reported that 15 large hedge funds were all in the same stock.
· June 29 – The Financial Times reported on the alarmingly high correlation of hedge funds to the equity markets (0.93).
· July 14 – Preqin study shows a mere 500 hedge funds control 90% or more of assets.
In essence, we’ve likely got a bunch of investors concentrated in a very few hedge funds that are highly correlated to the equity markets and who own the same stocks. Picture me making Macaulay Culkin’s face in “Home Alone.”
Diversification is a tricky thing. Investopedia describes it simply as a “risk management technique that mixes a wide variety of investments within a portfolio.” But maybe we need to think of diversification on a deeper level.
Homogeneous groups tend to think alike. They also tend to overestimate their problem solving skills and consider a narrower range of information.
They may also be less open to new ideas. The universe of hedge funds contains more than 10,000 funds. At the present time, there are fewer than 500 hedge funds managed by women and minorities. If you look in the dictionary under “homogenous” I bet there may actually be an illustrative photo taken at a hedge fund conference.
So I’d like to suggest that investors expand their definition of diversification. Maybe it’s not all about the asset allocation mix of stocks, bonds, futures, real estate and other asset classes. Perhaps it’s not even the number of funds you invest in or the mix of strategies you have. Maybe, just maybe, diversification includes the way in which the money managers collect, interpret and evaluate market data and the cognitive alpha they create for you.
You don’t think there’s a difference?
Talk to some women and minority managers about what they own. You might be surprised at how far their portfolios are off the beaten path. And then look at what the indices tell you. The HFRX Global Hedge Fund Index has produced a year-to-date net return of 1.77% through June. The HFRX Diversity Index has produced a 3.61% net return through the same period.
So the next time you’re meeting with a potential (or existing) hedge fund investment, look around the room. If you see a room filled with Matrix-esque Smith replications, you might want to go further down the rabbit hole to think about how market and company information is gathered, processed and acted upon by the fund. What does the fund own and how do those underlying portfolio positions interact with your other funds holdings? Are you really diversified or just in a lot of funds?
Or, of course, you can always take the blue pill.