Frictional Diversification Costs: Evidence from a Panel of Fund of Hedge Fund Holdings

51 Pages Posted: 19 Dec 2013 Last revised: 16 Mar 2018

See all articles by Juha Joenväärä

Juha Joenväärä

Aalto University School of Business

Bernd Scherer

EDHEC Business School - Department of Economics & Finance

Date Written: March 13, 2018

Abstract

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

Joenvaara, Juha and Scherer, Bernd, Frictional Diversification Costs: Evidence from a Panel of Fund of Hedge Fund Holdings (March 13, 2018). Available at SSRN: https://ssrn.com/abstract=2369188 or http://dx.doi.org/10.2139/ssrn.2369188

Juha Joenvaara

Aalto University School of Business ( email )

Finland

Bernd Scherer (Contact Author)

EDHEC Business School - Department of Economics & Finance ( email )

France

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