Onshore and Offshore Hedge Funds: Are They Twins?

Abstract

We undertake a comprehensive analysis of onshore and offshore hedge funds to study the effects of fund regulation and investor clienteles on a fund’s share restrictions, asset liquidity, flow-performance sensitivity, and performance. Liquid asset holdings and share restrictions on investor liquidity at the fund level, like lockup and redemption notice periods, are much more prevalent among US-domiciled (onshore) funds, which are subject to strict marketing prohibitions, accredited investor requirements, a limited number of investors, and taxable accounts. This evidence is consistent with onshore fund managers using financial and investment policies to more efficiently manage equity funding risk and potential tax externalities.

We also find that onshore and offshore hedge funds have a different flow-performance relationship. Capital flows to onshore funds are less sensitive to past performance among better performing funds, a result we attribute to differences in advertising restrictions between onshore and offshore funds.

Finally, we analyze the risk-adjusted performance of hedge funds after controlling all three types of liquidity risk (market liquidity, share liquidity, and asset liquidity), and find some evidence that onshore funds outperform offshore funds. This evidence is concentrated during the earlier part of our sample period, and consistent with previous research that shows increased capital flows to actively managed funds lead to decreasing returns to scale as documented by Berk and Green (2004) as well as Pastor and Stambaugh (2010).

A better understanding of the differences between onshore and offshore funds may shed light on the impact of current U.S. hedge fund regulation. The Dodd-Frank Act eliminates the registration exemption for onshore managers, thereby creating incentives for some managers to circumvent registration by opening offshore funds. Our results suggest that the impact of legislation on fund liquidity (e.g., lockup periods) and asset liquidity in the hedge fund industry should be considered from a policy perspective.

Keywords: offshore hedge funds, lock-up provision, liquidity risk, master-feeder structure

JEL Classification: G11, G12, G23, G32