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

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  • Joenväärä, Juha
  • Scherer, Bernd

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: n2∝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 .

Suggested Citation

  • Joenväärä, Juha & Scherer, Bernd, 2019. "Frictional diversification costs: Evidence from a panel of fund of hedge fund holdings," Journal of Empirical Finance, Elsevier, vol. 52(C), pages 92-111.
    • Handle: RePEc:eee:empfin:v:52:y:2019:i:c:p:92-111
    DOI: 10.1016/j.jempfin.2019.01.011
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    Keywords

    Hedge funds; Operational risk; Frictions; Portfolio selection; Diversification;
    All these keywords.

    JEL classification:

    • F14 - International Economics - - Trade - - - Empirical Studies of Trade
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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