Many people view a hedge fund as the diversification equivalent of a mutual fund. This is a mistake because a single hedge fund is not a diversified investment. A mutual fund is diversified because its performance depends, to a great extent, on the independent performance of the numerous management teams running the companies it owns. Hedge fund performance, on the other hand, depends almost exclusively on the decisions of one person-the hedge fund manager-regardless of how many positions the hedge fund holds.

This difference between hedge funds and mutual funds is due to the fact that mutual funds are portfolios of assets and hedge funds are not. In addition to owning stocks, hedge funds short stocks (a strategy designed to profit from declining prices), trade in and out of stocks and use other instruments such as futures, options or other derivatives that do not represent ownership of an asset like stocks do.

We recognize that hedge funds are companies that produce returns by providing a service (information processing) rather than broad market exposure to various assets. This concept is very important in hedge fund investing because hedge funds (like all businesses) are extremely risky. The only way investors can mitigate their exposure to these risks is through a diversified portfolio of many hedge funds.

Many people erroneously conclude that owning 5 to 10 hedge funds provides more than enough diversification. This has the same effect of putting all your money in 5 or 10 stocks. Chosen correctly, a concentrated portfolio of hedge funds can generate very high returns. However, the risk is too high because the failure of any one manager (which can and does happen all the time) can cause the portfolio to decline to a point from which it will never recover.

According to Modern Portfolio Theory, diversification is an important element that reduces the risk of a portfolio without diminishing returns. Approximately 98% of diversifiable risk is eliminated from a portfolio holding 50 - 100 hedge funds. PARADIGM currently is diversified among 75 managers and plans to reach 100 managers by 2003.

Past performance is not necessarily indicative of future results.