Frictional diversification costs:evidence from a panel of fund of hedge fund holdings

We analyze the diversification choices of fund of funds (FoF). Diversification is not a free lunch — not available for every FoF. Instead we 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: \(n^2 \propto AuM\). This relation is consistent with the predictions from a model of naïve diversification with frictional diversification costs such as due diligence costs. Finally, we demonstrate that individual FoFs diversifying more in line with our model’s predictions deliver superior performance and fail less likely.