Aurora Borealis
1 January 2015 CFA Institute Journal Review

Liquidity Risk and Economies of Scale in Funds of Hedge Funds (Digest Summary)

  1. Daniel J. Larocco

Recent literature has shown that large funds of hedge funds (FOFs) outperform smaller funds because of the economies of scale provided by the larger asset base. The authors examine the role that liquidity risk plays in explaining the economies-of-scale effect as indicated by the outperformance of large FOFs.

What’s Inside?

The traditional view of liquidity indicates that pricing impact and cost to trade negatively affect the returns of such funds as large mutual funds and hedge funds. Because large funds of funds (FOFs) invest in other hedge funds, liquidity may be less of a consideration; as a result, performance for large FOFs may improve. Thus, the authors investigate the extent to which lower levels of liquidity risk may be predictive of higher returns.

How Is This Research Useful to Practitioners?

FOFs represent approximately 25% of the assets managed within the hedge fund industry, with total assets under management of about $500 billion as of the end of 2011. The benefits of investing in FOFs include providing diversification across different strategies and the ability of FOFs to provide expertise with respect to due diligence.

But FOFs introduce another layer of management (and their associated fees), which has led to a long-running debate about the extent to which FOFs represent a value proposition for investors. The authors provide some useful insights. In particular, their research confirms that economies of scale lead to superior performance for large funds relative to small funds. But after they adjust for liquidity risk, the relationship between the returns of all large funds and those of all small funds is not consistent.

In particular, among the quintile with the lowest liquidity risk, large funds outperform small funds by 3.4% per year. In contrast, for the funds in the highest-liquidity-risk quintile, the authors do not detect any significant difference in performance based on fund size. As a result of this research, managers of large FOFs can improve overall performance by attempting to reduce liquidity risk.

How Did the Authors Conduct This Research?

The data are from the Lipper/TASS Hedge Fund Database for 1994–2011. Liquidity risk is measured based on a methodology developed in earlier research. Average returns are compared with a number of parameters, including the risk-free rate, the median return for FOFs, Carhart’s four-factor model, and Fung and Hsieh’s seven-factor model. Regression analysis is used to examine the extent to which liquidity risk explains the relationship between size and performance.

Abstractor’s Viewpoint

Hedge funds provide an important diversifying asset class for investors. At the same time, however, their rather substantial fee structures have caused many to question the extent to which they add value for hedge fund investors. FOFs reduce investment risk by providing important diversification advantages but at the cost of another layer of fees. As a result, on their own, FOFs do not clarify whether they add value for investors. The authors provide an important mechanism for improving FOF returns without sacrificing the advantages that FOFs provide to many investors.

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