Abstract
Using data from the Lipper TASS hedge fund database over 1994-2012, we examine the role of liquidity risk in explaining the relationship between asset size and hedge fund performance. While a significant negative size-performance relationship exists for all hedge funds, once we stratify our sample by liquidity risk, we find that such a relationship only exists among funds with the highest liquidity risk. This result cannot be explained away by the liquidity hypothesis or the leverage effect. Liquidity risk is found to be another important source of diseconomies of scale in the hedge fund industry. Evidently, for high liquidity risk funds, large funds are less able to recover from the more significant losses incurred during market-wide liquidity crises, resulting in lower performance for large funds relative to small funds.
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