Hedge funds — and any other asset or investment strategy for that matter — should be included in a portfolio until the marginal benefits of additional investment equal the marginal costs of additional investment.
An optimized portfolio is achieved when additional investments in each asset or strategy are equally attractive. In other words, exposure to each hedge fund strategy and manager, and to hedge funds overall, should be added until the net benefits have diminished to the point that allocations to other investments are equally attractive.
Using this simple framework, it is rather common to argue that small investors shouldn't consider direct investments in hedge funds and, instead, should use a fund-of-funds platform if they want exposure to hedge fund strategies. The reason is that creating a diversified portfolio of hedge funds costs money. Of course, having a concentrated portfolio of hedge funds costs money as well. The investor is exposed to strategy as well as manager risks.
On the other hand, it is highly unusual to argue that very large investors might have a difficult time justifying large absolute allocations to hedge funds. Interestingly, similar economic forces make investments in hedge funds challenging for both small and large asset allocators.
Suppose a small endowment decides to dedicate a portion of its portfolio to hedge funds. The initial cost of finding and evaluating a hedge fund is around $100,000. The annual monitoring cost will be around $50,000 per year. Of course, one may decide to cut some corners and spend less on due diligence, but there will be associated costs. Studies have shown that more than 50% of fund failures are due to operational risks. In addition, if enough resources are not spent on the evaluation of fund managers, there is a greater chance that a poor performing fund is selected. Even if one spends the full amount on fund evaluation, there is a reasonable chance that the fund will underperform its peers. After all, alpha generation is close to a zero-sum game and not all active managers can be above average.