Liquidity Risk and Economies of Scale in Funds of Hedge Funds

Using data from the Lipper/TASS hedge fund database over the period 1994-2011, the authors examine the effect of liquidity risk on the relationship between size and performance for funds of hedge funds (FOFs). After confirming a significant positive size effect for FOFs, they explicitly introduce liquidity risk and find that this scale effect becomes more pronounced among FOFs with lower liquidity risk. 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 helps 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.