Liquidity Risk and Economies of Scale in Funds of Hedge Funds
Posted: 1 Feb 2013 Last revised: 10 Apr 2014
Date Written: January 30, 2013
Using data from the Lipper/TASS hedge fund database over the period 1994-2011, we examine the impact of liquidity risk on the relationship between size and performance for funds of hedge funds (FOFs). We first confirm a significant positive size effect for FOFs. More importantly, once liquidity risk is accounted for, this scale effect is more pronounced among FOFs with lower liquidity risk. Specifically, for FOFs in the lowest liquidity risk quintile, the largest funds significantly outperform the smallest funds by an average eight-factor alpha of 4.7% per year; for FOFs in the highest liquidity risk quintile, however, we do not find a significant relationship between size and performance. To the extent that more illiquid FOFs exhibit higher liquidity risk, the results provide evidence in support of the 'liquidity' hypothesis that size does not erode, but instead help improve performance since FOFs do not directly manage portfolios of securities and thus are less affected by the liquidity costs associated with trading a large portfolio.
Keywords: liquidity risk, fund of hedge funds, asset size, performance, economies of scale
JEL Classification: G12, G14, G23
Suggested Citation: Suggested Citation