Frictional Diversification Costs: Evidence from a Panel of Fund of Hedge Fund Holdings

Using FoFs’ holdings data, the authors analyse the diversification choices of fund of hedge fund managers. Diversification is not a free lunch. It is not available for every fund of fund. Instead they 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 naive diversification (1/n) with frictional diversification costs such as due diligence costs.