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Diversification: How Much is Enough?

Diversification in the fund of funds industry is at present not thorough enough. A model of random stock-picking, combined with empirical data, shows how the benefits of diversification vary among asset classes. This is the result of differing costs of leverage and differing levels of diversifiable and nondiversifiable risk. A comparison of the costs and benefits of diversification for funds of CTAs and hedge funds indicates that typical portfolio sizes are suboptimally low.