Many investors confine their mutual fund holdings to a single fund family, either for simplicity or through restrictions placed by their retirement savings plan. We find evidence that mutual fund returns are more closely correlated within fund families, which reduces the benefits of investor diversification. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors.

We find evidence that hedge fund investors pool together measures of manager skill (alpha) with returns associated with traditional and exotic risk exposures (beta) when making capital allocation decisions. Institutional clienteles and those investing in high-fee funds appear more cognizant of exotic risks, and investors generally place greater relative emphasis on exotic risk returns over time. However, we find little evidence of persistence in performance from traditional or exotic risks, which suggests investors should adjust for these risks when evaluating fund performance rather than seeking them out following periods of success.JEL Classification: G11, G20