Frictional diversification costs: Evidence from a panel of fund of hedge fund holdings

Juha Joenväärä*, Bernd Scherer

*Corresponding author for this work

Research output: Contribution to journalArticleScientificpeer-review

Abstract

We analyze the diversification choices of fund of funds (FoF). Diversification is not a free lunch — not available for every FoF. 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 ∝AuM. This relation is consistent with the predictions from a model of naïve diversification 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.

Original languageEnglish
Pages (from-to)92-111
Number of pages20
JournalJOURNAL OF EMPIRICAL FINANCE
Volume52
DOIs
Publication statusPublished - 1 Jun 2019
MoE publication typeA1 Journal article-refereed

Keywords

  • Diversification
  • Frictions
  • Hedge funds
  • Operational risk
  • Portfolio selection

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