Frictional Diversification Costs: Evidence from a Panel of Fund of Hedge Fund Holdings
51 Pages Posted: 19 Dec 2013 Last revised: 16 Mar 2018
Date Written: March 13, 2018
We analyze the diversification choices of fund of hedge fund managers. Diversification is not a free lunch. It is not available for every fund of fund. Instead we find a positive log-linear relation between the number of constituent funds in a fund of hedge fund (n) and the respective assets under management, (AuM ). More precisely it takes the form: n^2 proportional to AuM. This relation is consistent with the predictions from a model of naïve diversification (1/n) with frictional diversification costs such as due diligence costs. Finally, we demonstrate that individual FoFs diversifying more in line with our model’s predictions deliver superior performance and fail less likely.
Keywords: diversification, hedge funds, fund-of-funds, frictional costs, operational risk
JEL Classification: F14, G14
Suggested Citation: Suggested Citation