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.