Strategic Asset Allocation is a theory of portfolio constructino that, as the name implies, places assets based on strategy as opposed to allocating to famous managers or strict return-seeking. Being able to allocate properly across strategies can be more important for your portfolio’s health than picking good managers, and a fund of hedge funds can be a good way to gain access to multiple strategies with one investment.

Q. So, we’re starting off Hedge Fund of Funds week today. Last time, we talked about the idea that a Fund of Funds is a way of making a single investment that gets the investor exposure to many kinds of hedge fund strategies. So what is Strategic Asset Allocation?
A. Strategic Asset Allocation, as you might guess, is a method of investing that focuses on what percentages of your assets you have in specific strategies … not which super star managers you want to invest in. Strategy allocation has been shown to be more statistically important than individual fund manager selection over time. To say it differently, its more important to be a good allocator than it is to be a good fund picker… although, of course, you ideally want both.

Q. So the point of a FoF is that I get someone doing this critical allocation function across different hedge fund strategies for me?
A. Yes, exactly. And, another important point is that FoF can get smaller investors access to HFs with high minimums by aggregating their dollars.

Q. So, in the context of a Fund of Funds, I guess the issue our buzzword raises is: how many underlying funds should a FoF be invested in? How many strategies?
A. Ha, there’s been a ton of academic and marketing ink spilt on that issue. Certainly you want exposure to all the basic strategies: equity and credit long-short, commodities, non-U.S. So a minimum of five or six. But there are many other kinds of more exotic strategies, that can take the strategy list up to 15 or 20. Some FoF invest in literally 100 managers or more… BUT some very high quality studies have shown that, beyond about 20 investments, FoF performance tends to decrease.

Q. Why in the world would that be? Isn’t more diversification always better?
A. You’d think so, but there are probably two reasons why not. The first is that you start having cross-correlation; that is, managers may not be correlated to equity markets, but they might well be correlated to each other. This is a really critical point, because then adding new managers can actually decrease diversification. The second reason, frankly, relates to quality control: how many managers can you pick and oversee well? There’s probably a maximum there.

Q. So, what else should a prospective investor in a FoF think about?
A. Other things we’ll take up this week: fee structures, of course; and how well ETFs and mutual funds – which are cheaper and more liquid than traditional FoFs—can replicate their behavior.