Aragon Et Al 2013 Onshore and Offshore Hedge Funds Are They Twins

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Onshore and Offshore Hedge Funds: Are They Twins?

George Aragon, Bing Liang, Hyuna Park
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George Aragon, Bing Liang, Hyuna Park (2014) Onshore and Offshore Hedge Funds: Are They Twins?. Management Science
60(1):74-91. https://doi.org/10.1287/mnsc.2013.1729
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MANAGEMENT SCIENCE
Vol. 60, No. 1, January 2014, pp. 74–91
ISSN 0025-1909 (print) ISSN 1526-5501 (online) http://dx.doi.org/10.1287/mnsc.2013.1729
© 2014 INFORMS
Onshore and Offshore Hedge Funds:

Are They Twins?
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George Aragon
W.P. Carey School of Business, Arizona State University, Tempe, Arizona 85287, george.aragon@asu.edu
Bing Liang
Isenberg School of Management, University of Massachusetts, Amherst, Massachusetts 01003, bliang@isenberg.umass.edu
Hyuna Park
College of Business, Minnesota State University, Mankato, Mankato, Minnesota 56001, hyuna.park@mnsu.edu
C ontrary to offshore hedge funds, U.S.-domiciled (“onshore”) funds are subject to strict marketing prohibi-
tions, accredited investor requirements, a limited number of investors, and taxable accounts. We exploit
these differences to test predictions about organizational design, investment strategy, capital flows, and fund
performance. We find that onshore funds are associated with greater share restrictions, more liquid assets, and
a reduced sensitivity of capital flows to superior past performance. We also find some evidence that onshore
funds outperform offshore funds, depending on the sample period. The results suggest that a fund’s investment
and financial policies reflect differences in investor clienteles and the regulatory environment.
Key words: offshore hedge funds; lockup provision; liquidity risk; master-feeder structure
History: Received October 27, 2010; accepted January 31, 2013, by Wei Xiong, finance. Published online in
Articles in Advance August 19, 2013.
1. Introduction regulatory concerns.3 They also have access to capital

Despite important differences in investor tax outside the United States through several distribution
clienteles and regulatory environments, most hedge channels in addition to private placements, including
fund studies do not distinguish between funds banks and investment managers.4
that are domiciled in the United States (“onshore”) Onshore and offshore funds also differ in their legal
and those registered in low-tax jurisdictions such structures, which attract investor clienteles with dis-
as the Cayman Islands and British Virgin Islands tinct tax requirements. Most onshore funds are orga-
(“offshore”).1 To avoid registration and substantive nized as limited partnerships so that taxable income
regulation under the Investment Company Act of is “passed through” to fund investors rather than
1940, onshore managers must limit the number taxed at both the investor and entity levels (McCrary
(at most 100 or 499) and type (accredited or quali- 2002). Although a partnership structure is attractive to
fied) of fund investors, are prohibited from public U.S. taxable investors, it exposes tax-exempt investors
offerings of fund shares, and can only use private to unrelated business taxable income (UBTI) that is
placements to solicit U.S. investors.2 In contrast, generated from leveraged investments (LePree 2008).
offshore managers are generally not concerned with Offshore funds, on the other hand, are generally orga-
these requirements, to the extent that they do not nized under a corporate structure that avoids UBTI,
offer their shares to U.S. taxable investors. Merely making them more appealing to tax-exempt investors,
investing into or maintaining custody of assets in
like endowments and pension funds, in addition to
the United States does not trigger substantive U.S.
non-U.S. investors.5
1
One exception is Brown et al. (1999), who study offshore fund
3
performance and attrition specifically by using data from the U.S. See Barth and Blanco (2001).
4
Offshore Funds Directory. Cumming and Dai (2010) summarize the regulations of hedge
2
See §§3(c)(1) and 3(c)(7) of the Investment Company Act of funds across 29 countries. They find (their Table 1), in contrast to
1940. Although a fund can have an unlimited number of quali- offshore fund managers, that onshore fund managers are restricted
fied investors under the §3(c)(7) exemption, a fund having more to only one (private placement) of a possible seven distinct market-
than 499 investors would trigger registration under the Security ing channels: banks, fund distribution companies, wrappers, pri-
Exchange Act of 1934. Also, in addition to avoiding fund regis- vate placements, investment managers, other regulated financial
tration, managers of onshore funds further rely on an exemption service institutions, and nonregulated financial intermediaries.
5
from registering with the U.S. Securities and Exchange Commission U.S. taxable investors face tax rules that may discourage them
(SEC) under the Investment Advisers Act. from investing in offshore funds (Gross 2004).
74
Aragon, Liang, and Park: Onshore and Offshore Hedge Funds: Are They Twins?
Management Science 60(1), pp. 74–91, © 2014 INFORMS 75
In this paper we present a comparative analy- Furthermore, because onshore funds primarily attract
sis of onshore and offshore hedge funds over the taxable investors, there would be a stronger incentive
period 1994–2010. Our empirical work is guided by to minimize tax externalities that might result from
fundamental differences between onshore and off- liquidity-motivated trading.
shore funds (outlined above), which we argue can Moreover, share restrictions limit the ability of
impact investment management and shed light on hedge fund investors to exchange their interests in a
several important economic questions. First, how do timely fashion, unlike trading on an established secu-
managers contract with investors to achieve greater rities market. Restricted trading of the fund’s shares
efficiency? Hedge fund managers can, for instance, allows onshore funds—typically structured as lim-
impose lockup and redemption notice periods to curb ited partnerships—to avoid being qualified as pub-
redemptions, thereby limiting nondiscretionary trad- licly traded partnerships (PTPs). PTPs are treated as
ing and the realization of capital gains. Second, do corporations for tax purposes, which brings with it
regulatory restrictions on a manager’s ability to raise the prospect of double taxation. In contrast, the above
new capital—limits on the fund’s marketing chan- considerations would not apply as strongly to off-
nels and the number and type of investors—influence shore funds, which are not organized as U.S. partner-
the fund’s investment strategy? Presumably, man- ships and attract nontaxable institutional investors.
agers are less inclined to hold illiquid assets if they The discussion above leads to our Share Restric-
are unable to quickly raise new capital to offset tions Hypothesis, which states that onshore hedge
redemption requests and, as a result, avoid nondiscre- funds impose greater share restrictions than their off-
tionary trading costs. Furthermore, how do the above shore counterparts—that is, longer lockup periods,
regulatory restrictions impact fund flows and perfor- less frequent redemption and subscription periods,
mance? Answers to these questions help fill an impor- and larger initial investment requirements.
tant gap in the literature and shed light on whether Indeed, our empirical evidence shows that onshore
two large segments of the industry differ in econom- funds have an average lockup period that is dou-
ically important ways or, instead, whether onshore ble that of offshore funds (5.6 versus 2.8 months),
and offshore funds are essentially twins. and also have a significantly higher redemption notice
Our first hypothesis is about the share restric- period (41 versus 37 days). We observe a similar
tions (like lockups and notice periods) used by relation when we compare other share restriction
open-ended funds to limit the ability of investors variables; in particular, onshore funds are associ-
to redeem fund shares. Prior studies indicate that ated with a significantly higher minimum investment
investor redemptions can induce liquidity-motivated and less frequent redemption and subscription cycles.
trading of the fund’s portfolio. This may reduce prof- Whereas prior studies focus on the link between
itability because it generates nondiscretionary trading
redemption restrictions and asset illiquidity (Aragon
costs (Edelen 1999). In addition, liquidity-motivated
2007, Sadka 2010), our findings point to an additional
trading may accelerate the realization of capital gains,
tax efficiency role for share restrictions in open-ended
creating significant tax externalities on the remain-
funds.7
ing shareholders (Dickson et al. 2000). Extensive use
Next, we examine whether constraints on a man-
of leverage, common among hedge funds (Ang et al.
ager’s ability to raise new capital, as in onshore
2011), can magnify these effects, should withdrawals
funds, influence a fund’s decision to hold illiquid
trigger margin calls that require a further liquida-
assets. Nondiscretionary trading costs are likely to be
tion of securities (Shleifer and Vishny 1997). Man-
larger for funds holding less liquid assets. Managers
agers can attenuate these effects either by raising new
can dampen the effects of these liquidity shocks by
capital to offset redemption requests or by imposing
either raising new capital or investing in more liq-
share restrictions on investors to curb redemptions.
Due to regulatory constraints on raising capital (i.e., uid assets. Facing regulatory constraints on the num-
restrictions on the number and type of accounts and ber of accounts and their ability to issue new shares,
the availability of a single channel to solicit new onshore funds may be more inclined to hold more
investors), we expect onshore funds to rely more liquid assets to reduce trading costs. Conversely, off-
on share restrictions because offsetting outflows with shore funds, which have access to additional funding
inflows of new capital would be more difficult.6 channels, could hold more illiquid assets. This forms
our Asset Illiquidity Hypothesis, which predicts that
6
The role of lockups in managing redemptions in open-ended
7
funds has been examined by Chordia (1996), Nanda et al. (2000), Similarly, Sialm and Starks (2012) find that load fees are much less
Lerner and Schoar (2004), and Aragon (2007). The prevailing mech- common among mutual funds with more tax-deferred investors.
anism is that lockups allow funds to attract investors that are less Other papers on the tax externalities of mutual funds include
likely to experience a liquidity shock and therefore have a longer Dickson et al. (2000), Bergstresser and Poterba (2002), Shoven and
investment horizon. A similar mechanism drives the equilibrium Sialm (2003), Barclay et al. (1998), Ivković and Weisbenner (2009),
described by Amihud and Mendelson (1986). and Bergstresser and Pontiff (2013).
76 Management Science 60(1), pp. 74–91, © 2014 INFORMS
onshore hedge funds hold assets with greater liquid- we estimate that an increase in an offshore fund’s rel-
ity and lower liquidity risk than do offshore funds.8 ative performance from 33rd to 1st (i.e., across the
We find that the portfolios of onshore funds contain top tercile) is associated with an increase in quar-
more liquid assets and assets with lower market terly flows of 8%. In contrast, for onshore funds, the
liquidity risk than do offshore funds. In particu- same jump in performance leads to a quarterly flow
lar, onshore funds are less common among “illiq- increase of only 4.2%. The reduction in the sensitivity
uid” style categories, such as emerging markets, of flows to performance among onshore funds is sig-
convertible arbitrage, fixed income arbitrage, and nificant and not fully explained by the greater use of
multistrategy. We also find a similar pattern using share restrictions.
return-based measures of asset illiquidity and liq- Finally, we link our findings under the Fund Flow
uidity risk. For example, offshore funds have a Hypothesis to the theoretical work of Berk and Green
significantly greater monthly return autocorrelation (2004) and Pastor and Stambaugh (2012). They posit
(Getmansky et al. 2004) and a greater market liquid- that a manager faces decreasing returns to scale
ity beta, in the sense of Pastor and Stambaugh (2003) from asset management, and investors will supply
and Sadka (2006, 2010). We interpret this evidence as capital competitively as they learn from past per-
support for our Asset Illiquidity Hypothesis. formance. As a result, in the Berk–Green equilib-
Existing evidence suggests that investors’ search rium, abnormal returns are eliminated as investors
costs are an important determinant of fund flows; in direct more capital to superior managers. A key
particular, greater marketing efforts by mutual funds assumption in their model is perfect competition
result in strong performance-flow sensitivity, espe- among investors for manager skill. However, since
cially for high-performing funds (Sirri and Tufano onshore funds are constrained in their marketing
1998, Huang et al. 2007). Thus, regulatory constraints efforts to solicit new investors, we would expect
on marketing efforts of onshore funds would lead to a weaker flow-performance relation among high-
lower performance-flow sensitivity when compared performing onshore funds. In other words, high-
with offshore funds. In this situation, the demand performing onshore funds would continue to perform
for onshore investment management services would well since incremental investor capital is less likely to
fall since such funds would be less visible to new chase away performance. Meanwhile, offshore funds
investors, reducing the amount of capital deployed.
(which can presumably solicit new investors unhin-
On the supply side, onshore fund managers would
dered by those regulatory restrictions) would deliver
be less inclined to hold illiquid assets to compensate
lower risk-adjusted performance. Our Fund Perfor-
for the added difficulty in finding replacements for
mance Hypothesis states that offshore funds conform
investors that leave the fund for liquidity reasons.
more closely to the predictions of Berk and Green
This leads to our Fund Flow Hypothesis, which states
(2004), delivering lower risk-adjusted performance
that the flow-performance relation is less sensitive for
compared with their onshore counterparts because
onshore than offshore funds, especially among the
offshore fund profits are chased away by unrestricted
high performers.9
capital flows.10
Our empirical analysis reveals that onshore funds
We find that onshore funds outperform offshore
are associated with significantly lower assets under
funds over the first half of our sample period
management ($226 million versus $112 million) and,
in line with our Fund Flow Hypothesis, a lower sen- (1994–2001); The average eight-factor model alpha
sitivity of net investor flows to superior past perfor- of onshore funds is significantly higher (0.63 versus
mance compared with offshore funds. For example, 0.30% per month). The difference is also significant
after adjusting for share restrictions and asset illiq-
8
uidity and robust to a bootstrap test for whether per-
Of course, if the share restrictions are effective, then onshore funds
formance can be explained by pure luck. The supe-
may not need to hold more liquid assets to be able to deal with out-
flows. It is, therefore, an empirical question whether this opposing rior performance of onshore funds, however, does
effect can fully offset onshore fund managers’ need to hold more not persist over the latter part of our sample period
liquid assets in anticipation of dealing with outflows. (2002–2008). This evidence is largely consistent with
9
Bergstresser and Poterba (2002) study U.S. mutual funds held the Fung et al. (2008) empirical finding of decreasing
by taxable investors and find that funds with greater unreal-
ized capital gains (“tax overhang”) experience lower outflows and
10
lower inflows. We would expect similar effects on onshore funds Recently, Pastor and Stambaugh (2012) extended the Berk and
since these funds are also held by taxable U.S. investors. Unlike Green (2004) model by assuming that the decreasing returns to
Bergstresser and Poterba (2002), however, we only observe net scale happens at the entire industry level. One caveat is that these
flows in hedge fund data rather than the component inflows and models assume no incentive fee because they are developed to
outflows. The predicted impact of tax overhang on net flows is explain the flow-performance relation in mutual funds. However,
ambiguous since it will depend on whether the outflow or inflow incentive fees are an important part of the compensation package
effects dominate. for hedge fund managers.
returns to scale in the hedge fund industry. We con- Figure 1 Hedge Fund Assets by Domicile Country
clude that any constraints faced by onshore managers 400
AUM growth rate
in growing fund assets do not appear to have a long- (Jan 1994–Dec 2010, % per year)
350
run cost in terms of having to share rents with fund Offshore funds 18.2%
investors in the form of greater after-fee returns. The 300 Onshore funds 12.3%
AUM (US$ billion)

results also suggest that any tax-efficiency motives Other funds 11.6%
250
of onshore fund managers do not lead to significant
constraints on investment strategies, which would be 200

reflected as lower risk-adjusted returns.11 Offshore
150
The findings summarized above contribute to a Onshore
large hedge fund literature. To our knowledge, our 100 Others
paper is the first to compare onshore and off-
50
shore funds and find key differences in investment
strategies, share restrictions, capital flow, and perfor- 0
Jan. 94
Oct. 94
July 95
Apr. 96
Jan. 97
Oct. 97
July 98
Apr. 99
Jan. 00
Oct. 00
July 01
Apr. 02
Jan. 03
Oct. 03
July 04
Apr. 05
Jan. 06
Oct. 06
July 07
Apr. 08
Jan. 09
Oct. 09
July 10
mance. This is important because although the hedge
fund industry has experienced rapid growth, offshore
funds, in particular, have grown even faster than
onshore funds (see Figure 1).12
Assets under
Furthermore, prior studies find that top-performing
management
hedge funds can consistently deliver alpha and that Number of funds (AUM, US$ billion)
positive alphas reflect compensation for holding illiq-
uid fund shares.13 In our analysis of hedge fund per- Jan. 1994 Dec. 2010 Jan. 1994 Dec. 2010
formance, we are also the first to control for and find Offshore funds 136 726 12085 186002
significant explanatory power of three distinct types 439%5 453%5 (53%) (72%)
of liquidity risk: market liquidity (a systematic risk Onshore funds 194 528 9027 59051
factor as in Pastor and Stambaugh 2003 and Sadka 455%5 439%5 (38%) (23%)
2010), share liquidity (share restrictions as in Aragon Other funds 21 108 2020 12081
2007), and asset liquidity (idiosyncratic illiquidity that 46%5 48%5 (9%) (5%)
causes serial correlation as in Getmansky et al. 2004).14 Notes. Onshore funds are domiciled in the United States. Offshore funds
Evidence in this paper also supports a grow- are domiciled in low-tax jurisdictions such as Cayman Islands, British
ing literature on the influence of tax clienteles on Virgin Islands, Bermuda, Bahamas, Netherlands Antilles, Mauritius, St. Kitts
investment management. Prior studies find that effi- and Nevis, Saint Lucia, Barbados, and Anguilla. Other funds are domi-
ciled in Europe, Canada, Latin America, Asia, Australia, and the Middle East
ciency motives influence a manager’s trading behav- (35 countries).
ior (Barclay et al. 1998, Sialm and Starks 2012) and the
dynamics of investor flows (Bergstresser and Poterba
2002). Although this literature looks at mutual funds,
important for hedge funds—in particular, in the liq-
our evidence suggests that tax clienteles are also
uidity restrictions that managers impose on investors.
Finally, our results are generally consistent with the
11
This finding supports Sialm and Starks (2012), who do not find a competitive markets view for our sample of hedge
strong relation between mutual fund performance and investor tax funds. In particular, we find no evidence of positive
clienteles.
12
alpha on average among offshore hedge funds, where
The assets under management of offshore funds grew by 18.2%
the premise of competitive supply of capital is more
per year over 1994–2010, as compared with only 12.3% per year
for onshore funds. As a result, as of December 2010, offshore funds likely to be satisfied. In addition, although we find
command 72% of the total industry’s assets under management, as evidence that onshore funds outperform during the
compared with just 53% in January 1994. earlier part of our sample period, we find no such
13
See, for example, Fung and Hsieh (1997, 2004), Ackermann et al. difference over the more recent period. We conclude
(1999), Brown et al. (1999), Liang (1999), Agarwal and Naik (2004),
that capital flows reduce a manager’s ability to deliver
Kosowski et al. (2007), Fung et al. (2008), Jagannathan et al. (2010),
Aragon (2007), Bali et al. (2007), and Getmansky et al. (2011). alpha because of decreasing returns to scale for both
14
We distinguish asset liquidity from share liquidity, whereas pre- onshore and offshore funds, albeit at a slower rate for
vious research assumes a positive relation between share restric- onshore managers, who can only raise capital in the
tions and asset illiquidity and uses share restrictions such as a U.S. through private placements.
lockup provision as a proxy for asset illiquidity. See §§2.3 and 3.4
The rest of this paper is organized as follows: Sec-
for details on how we control for market liquidity, asset liquidity,
and share liquidity when measuring risk-adjusted performance of tion 2 describes the data and summary statistics. Sec-
hedge funds. tion 3 presents empirical results. Section 4 concludes.
2. Data and Summary Statistics not allowed to redeem the shares of a fund without
In this section we discuss the data used in the empir- a penalty. As in previous research, we use a dummy
ical analysis, explain the variables used to benchmark variable instead of the lockup period because the
fund returns and to measure market liquidity risk and lockup period is clustered around zero (for 68% of
asset illiquidity, and present summary statistics for the funds) and 12 months (for 24% of the funds). RF
the key variables. and SF show the frequency at which the fund pro-
cesses investor redemption and subscription requests.
2.1. TASS Database RNP is the length of an advance notice period that
We obtain individual hedge fund data from Lipper investors should give a fund manager before cashing
TASS (hereafter, TASS)—a major hedge fund data in the fund shares. Note that lockup is a one-time
vendor. The database provides monthly net-of-fee restriction applied only to new investors, whereas
returns; assets under management (AUM); and other other variables are rolling restrictions applied to all
fund characteristics such as investment style, legal investors.
structure, domicile country, management company,
fee structure, and share restriction provisions. 2.2. Benchmarking Hedge Fund Returns
We include both live funds and defunct funds to We estimate the risk-adjusted performance of hedge
avoid survivorship bias. Because TASS does not retain funds using an eight-factor model that includes the
data on defunct funds before 1994, our sample period seven factors of Fung and Hsieh (2004) and also a
starts in January 1994 and ends in December 2010. market liquidity factor. The first seven factors include
As of December 31, 2010, there are 10,176 hedge funds the excess return on the Standard & Poor 500 Index;
that report monthly net of fee returns to TASS, of the size factor as in Fama and French (1993); the
which 4,249 are live and 5,927 funds are defunct. excess return on the Fama Treasury bond portfo-
We reduce backfill bias by deleting all returns that lio with maturities greater than 10 years; the excess
occur before the fund was added to TASS. In our return on the Citigroup Corporate BBB 10+ year
analysis of fund performance, we estimate an eight- index minus the excess return on Fama Treasury bond
factor model at the fund level. Therefore, we require portfolio with maturities greater than 10 years (as in
that each fund have at least 36 monthly returns to be Jagannathan et al. 2010); and the excess returns on
included in the analysis. There are 4,324 funds that portfolios of look back straddle options on curren-
meet this requirement. cies, commodities, and bonds (as in Fung and Hsieh
Among the 4,324 funds, 1,234 are domiciled in the 2001).16 In addition, we include a liquidity risk factor
United States and 1,229 of them report returns in U.S. as in Pastor and Stambaugh (2003) and Sadka (2006).
dollars. We define the 1,229 funds as onshore hedge The Pastor and Stambaugh (2003) liquidity factor is
funds. Among the remaining 3,090 funds in the group based on the principle that order flows induce greater
of 4,324 funds, 2,302 are domiciled in the nine low-tax return reversal when liquidity is low, whereas Sadka’s
jurisdictions in the Caribbean or in Mauritius: 1,641 in (2006) liquidity factor is based on the permanent vari-
Cayman Islands; 314 in British Virgin Islands: 238 in able component of the intraday price impact of stock
Bermuda; and 109 in Bahamas, Netherlands Antilles, trades.17 We use January 1994 through December 2008
Mauritius, Anguilla, Barbados, Saint Kitts and Nevis, as the sample period for estimating the eight-factor
or Saint Lucia. Among the 2,302 funds, 1,710 report model alpha because the trend-following and liquid-
returns in U.S. dollars. We define these 1,710 funds as ity factor data were not available for later months at
offshore funds.15 That is, our “backfill-adjusted sam- the time of our empirical tests.
ple” has 2,939 funds: 1,229 onshore and 1,710 offshore
funds. 2.3. Measuring Asset Illiquidity and
Finally, when analyzing the relation between share Market Liquidity Risk
illiquidity and asset illiquidity, we use five share Getmansky et al. (2004; hereafter, GLM) argue that
restriction variables available in TASS: lockup period, the serial correlation in hedge fund returns can be
redemption frequency (RF), redemption notice period attributed, in part, to illiquid assets held in the
(RNP), subscription frequency (SF), and the minimum
investment amount (MinInv). The lockup period spec- 16
We thank Kenneth French and David Hsieh for providing down-
ifies a time interval during which a new investor is loadable data on their websites. The size factor was obtained from
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_
15
The remaining 592 offshore funds report returns in a foreign library.html and the trend-following factors were downloaded
currency and are not included in our sample. However, our main from http://faculty.fuqua.duke.edu/∼dah7/HFRFData.htm on
findings are qualitatively unchanged when we expand our offshore March 15, 2011.
17
category to include these funds after using prevailing exchange The results reported in this paper are based on Sadka’s (2006)
rates to convert the foreign currency returns into U.S. dollar liquidity factor, but we reach similar results when we repeat our
returns. analysis using the Pastor and Stambaugh (2003) liquidity factor.
fund’s portfolio. Therefore, Lo (2001), GLM (2004), case of offshore funds, the most frequently observed
and Khandani and Lo (2007) suggest using the first- legal structure is open-ended investment company
order serial correlation coefficient () of a fund’s (32.98%), but the proportion varies across locations
returns as a measure of asset illiquidity. (26.62% for Cayman Island and 53.05% for British
GLM (2004) also suggest another measure of Virgin Islands). As previously discussed, corporate
asset illiquidity by distinguishing between a fund’s structures are less frequent among onshore funds
reported returns and economic returns. The idea is because corporations are subject to double taxation in
that the reported returns of illiquid portfolios only the United States.20
partially reflect the true economic returns contempo- Panels A and B of Table 2 compare other char-
raneously but the economic returns are incorporated acteristics of onshore and offshore funds by style
into reported returns eventually. The key parameter categories. Among the most striking observations is
of their model, 0 , represents the fraction of a fund’s that 16.3% of offshore funds are classified as emerg-
economic return that is simultaneously incorporated ing markets, as compared with just 3% for onshore
in its reported return. Hence, a lower 0 means a more funds. The emerging markets style category is gen-
illiquid portfolio. Therefore, we call = 1 − 0 the erally associated with greater asset illiquidity (see
GLM (2004) measure of asset illiquidity.18 We use both Table 8 in GLM 2004). Therefore, its relative pop-
the GLM (2004) illiquidity measure () and the first- ularity among offshore funds provides preliminary
order serial correlation coefficient () to test our Asset support for the Asset Illiquidity Hypothesis—that
Illiquidity Hypothesis.19 is, managers choose offshore domiciles (and, as we
We also compare the market liquidity betas ob- argue, greater funding liquidity) in anticipation of
tained from the eight-factor model described above. greater asset illiquidity. Alternatively, this finding is
As previously discussed, prior studies show that mar- also consistent with comparative advantages that can
ket liquidity is a priced risk factor in the cross- result from a fund’s proximity to its investments.21
section of stock returns (Pastor and Stambaugh 2003, Emerging markets hedge funds may also be
Sadka 2006) and hedge fund returns (Sadka 2010). attracted by tax treaties that domicile countries have
The impact of market liquidity on hedge funds is also with the target investment country. For example,
evident from the collapse of Long-Term Capital Man- under the current tax treaty between Mauritius and
agement in 1998 and the recent liquidity crisis of 2007 India, capital gains on Indian shares held by a
to 2009. Mauritian fund are not subject to Indian tax and are
only taxed at Mauritian tax rates, which are extremely
2.4. Summary Statistics low. Using TASS data on hedge funds’ geographical
In Table 1 we present summary statistics for our focus, we find (not tabulated) that 78% of Mauritius-
main sample of hedge funds by domicile country. The domiciled emerging markets hedge funds are geo-
vast majority of offshore funds are domiciled in the graphically focused in India, as compared with just
Cayman Islands (1,161), followed by the British Virgin 11% for all emerging markets offshore funds. How-
Islands (262). The table also shows that offshore funds ever, despite this example, the prevalence of off-
on average have more assets under management com- shore domiciles among emerging markets funds is
pared with onshore funds. This is consistent with our unlikely to be fully explained by complementary tax
hypothesis that the registration exemption require- treaty networks because offshore countries have col-
ments faced by onshore funds, like the limit on the lectively signed relatively few tax treaties with emerg-
number of investor accounts and restrictions on pub- ing markets countries. In fact, besides Mauritius and
lic advertising, restrict capital flows to onshore funds.
Table 1 also shows that 83% of onshore funds are 20
We also find that some mutual funds register in offshore jurisdic-
limited partnerships (LPs), whereas only 3.5% of off- tions. Similar to offshore hedge funds, offshore mutual funds are
shore funds operate under such a structure. In the largely free from U.S. regulation and provide favorable tax treat-
ment for tax-exempt investors. We do not pursue an analysis of
onshore and offshore mutual funds, however, since only 0.41% of
18
See GLM (2004) for further details. As in GLM (2004), we use two our funds are onshore mutual funds.
lags and assume that the demeaned economic returns are mean- 21
Teo (2009) finds that hedge funds with a physical presence (head
zero, normal random variables and use the previous 60-month or research office) in their investment region outperform other
return history of a fund to estimate all model parameters by maxi- hedge funds and especially so for emerging market funds. Teo
mum likelihood. (2009) also finds that emerging market funds that are located near
19
We find that results using and are similar, but the requirement the market or employ native speakers outperform funds located in
of 60-month return history to estimate reduces the sample size the United States or the United Kingdom. We checked the company
from 2,939 (1,710 offshore and 1,229 onshore) to 1,606 (876 offshore addresses of all management firms for the 1,710 offshore funds
and 730 onshore). Therefore, the main results reported in this paper in our sample. Consistent with Teo’s conclusions, these offices are
use as a measure of asset illiquidity in order to maintain a large distributed across 51 different countries, whereas 95% of onshore
sample size. funds have a management company located in the United States.
Table 1 Legal Structure of Hedge Funds by Domicile Country
Legal structure (%)
Exempted Open-
Limited Open-ended limited ended International
No. of Average Limited liability investment Exempted liability mutual business Other
Domicile country funds AUM ($mm) partnership company company company company fund company structuresa
Onshore funds 11229 111086 83008 11055 1014 0033 0000 0041 0000 3050
Offshore funds 11710 226010 3051 9088 32098 16014 13086 4074 3039 15050
Cayman Islands 11161 212058 3070 8079 26061 23017 19038 3010 0000 15025
British Virgin 262 324038 3044 7025 53005 0076 0038 5034 17056 12021
Islands
Others 287 183033 2079 16072 40042 1074 3083 10080 4018 19051
Notes. This table compares offshore hedge funds with onshore funds in terms of fund size (measured by the average value of assets under management (AUM)
during the fund life) and legal structure (form of organization). Onshore funds are registered in the United States. Offshore funds are registered in low-tax
jurisdictions such as the Cayman Islands, British Virgin Islands, Bermuda, Bahamas, Netherlands Antilles, Mauritius, St. Kitts and Nevis, Saint Lucia, Anguilla,
and Barbados. The data is from the TASS database, and the sample period is from January 1994 to December 2010.
a
Other structures are closed-ended investment company, exempted unit trust, individual managed account, limited corporation, protected cell company,
segregated portfolio company, and unit trust.
Barbados, no offshore country in our sample has level with the t-statistics ranging from 3.44 to 15.58.
signed any such tax treaty as of the end of our sample Our results support the Share Restrictions Hypothe-
period.22 sis, according to which onshore funds are more likely
Finally, Table 2 also shows that onshore hedge to use share restrictions to retain investor capital and
funds are older than offshore funds (111.72 versus deter redemptions. This would allow onshore funds
93.24 months). As previously discussed, because of to mitigate the costs of nondiscretionary trading and
differences in tax status, onshore funds attract tax- increase tax efficiency since their ability to raise new
able U.S. individual investors whereas offshore funds capital is constrained.
attract non-U.S. persons and nontaxable U.S. institu- In §1 we discuss two sources of tax efficiency
tional investors (e.g., endowments, pension funds). that would result from the use of share restrictions
As a result, many U.S.-based managers start with an by onshore funds. The first involves delaying the
onshore fund simply because it is where they can realization of capital gains, which is valuable for tax-
invest their own money and where they can accept able investors. The second helps the fund avoid dou-
money from friends and family (see Strachman 2007). ble taxation that would result from qualifying as a
PTP. This is useful because the U.S. Internal Revenue
Code states that a PTP will be treated as a corpo-
3. Analysis and Results ration for taxation purposes if its interests are either
In this section we discuss our main findings asso-
traded on an established securities market or read-
ciated with the hypotheses—share restrictions, asset
ily tradable on a secondary market (or the substantial
illiquidity, fund flow, and fund performance—that
equivalent of such a market).23 By limiting the abil-
were proposed in §1.
ity of fund investors to exchange their interests in a
3.1. Share Restriction Hypothesis timely fashion, unlike trading on an established secu-
Panel C of Table 2 compares the usage of share restric- rities market, share restrictions make it less likely that
tions between onshore and offshore funds. For exam- an onshore fund would qualify as a PTP.
ple, the average lockup period of onshore funds is One concern is that the desire to avoid PTP status
about twice the lockup period of offshore funds (5.6 could be the sole explanation for the greater incidence
versus 2.8 months). On average, onshore funds also of share restrictions among onshore funds. If that
require a higher minimum investment amount and were the case, then we should not see any difference
have longer redemption, redemption notice, and sub- in the use of share restrictions between offshore and
scription periods than those for offshore funds. All
23
the differences are statistically significant at the 1% The definition of a substantial equivalent secondary market is
complex but considers whether “the partners are readily able to
buy, sell, or exchange their partnership interests in a manner that is
22
http://unctad.org/en/Pages/DIAE/International%20Investment%20 comparable, economically, to trading on an established securities
Agreements%20(IIA)/Country-specific-Lists-of-DTTs.aspx (accessed market.” See USC Title 26, Subtitle F, Chapter 79, §7704, and
August 22, 2012). The economic importance of the Mauritius/India 26 C.F.R. § 1.7704-1. Ramadorai (2012) notes that the tax consid-
case is further reflected in that 40% of all foreign investment into erations of a fund being traded on a secondary market are less
India flows from Mauritius (The Economist 2012). complicated for offshore funds.
Table 2 Share Restrictions and Other Characteristics of Hedge Funds by Investment Style and by Domicile Country
Panel A: Size and age
Total AUM ($ billion)

Number of funds as of December 2010 Average AUM ($mm) Age (months)
Investment style Onshore Offshore Onshore Offshore Onshore Offshore t-stat. Onshore Offshore t-stat.
∗∗∗
Convertible arbitrage 45 72 0028 2076 63052 299018 −2091 113022 101099 1019
Dedicated short seller 14 10 0004 0003 22073 46065 −20216∗∗ 117079 93000 1046
Emerging markets 37 279 1005 19081 119036 123020 −0008 106003 87044 2016∗∗
Equity market neutral 82 86 1008 1089 85086 154016 −2011∗∗ 107043 77094 4064∗∗∗
Event driven 163 182 6073 9005 205096 339010 −2054∗∗ 119054 103091 2052∗∗
Fixed income arbitrage 35 70 0038 3038 116030 266059 −3049∗∗∗ 95020 99014 −0050
Global macro 43 103 5034 51050 88072 445039 −2083∗∗∗ 96009 87025 1010
Long/short equity hedge 579 580 18074 24004 85083 168087 −4082∗∗∗ 107023 93091 4050∗∗∗
Multistrategy 104 196 8073 14012 155038 389047 −3003∗∗∗ 102060 98081 0059
Commodity trading advisors 127 132 9093 36015 138096 199065 −0089 147015 96020 6013∗∗∗
All funds 11229 11710 52030 162073 111086 226010 −7013∗∗∗ 111072 93024 9023∗∗∗
Panel B: Fees and other characteristics
Management fee (%) Incentive fee (%) High-water mark (%) Leveraged (%)
Investment style Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore Onshore Offshore
Convertible arbitrage 1021 1044 −2099∗∗∗ 18022 19031 −1023 73033 66067 71011 83082
Dedicated short seller 1009 1059 −2028∗∗ 17032 19000 −0077 50000 70000 50000 60000
Emerging markets 1056 1059 −0044 18043 18032 0016 67057 74019 56076 62093
Equity market neutral 1025 1044 −2056∗∗ 19006 19015 −0010 71095 75058 50000 46051
Event driven 1057 1048 0057 18046 18061 −0027 71078 65038 52015 60044
Fixed income arbitrage 1027 1049 −2049∗∗ 20000 20022 −0042 80000 67014 82086 85071
Global macro 1045 1061 −1037 19019 18098 0023 76074 66002 74042 88035
Long/short equity hedge 1020 1038 −7018∗∗∗ 19020 19006 0058 76068 70017 59024 62067
Multistrategy 1055 1056 −0021 19005 18006 1073∗ 81082 69040 67027 60045
Commodity trading advisors 2002 1096 0042 19033 19098 −0091 35043 73048 77017 84073
All funds 1038 1052 −4039∗∗∗ 18098 18096 0013 72074 70099 61011 66061
Panel C-1: Share restrictions (all funds)
Lock-up period Minimum investment Redemption notice Redemption frequency Subscription frequency
(months) ($mm) period (days) (days) (days)
Investment style Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat.
Convertible arbitrage 3060 4050 −0080 0097 1001 −0017 45011 47085 −0066 72095 73094 −0010 34000 32069 0046
Dedicated short seller 3043 2040 0049 0055 0054 0009 34071 26050 0081 92031 60000 1030 51043 30000 2069∗∗
Emerging markets 3089 2025 1066 0058 0059 −0008 40054 39038 0029 73071 46089 2075∗∗∗ 39073 28084 2092∗∗∗
Equity market neutral 3084 1071 2058∗∗ 1020 0071 2005∗∗ 35046 27015 2043∗∗ 61014 40036 4091∗∗∗ 38094 31029 2077∗∗∗
Event driven 7059 5077 1086∗ 1064 1030 1014 56087 56048 0010 148036 80048 5083∗∗∗ 37064 33024 2034∗∗
Fixed income arbitrage 3094 1067 2020∗∗ 0089 1016 −1010 51043 41074 1085∗ 94055 64041 1080∗ 38057 34041 1002
Global macro 3035 1008 2034∗∗ 1013 1046 −0085 33012 23094 2052∗∗ 52071 39055 2052∗∗ 35071 29067 2014∗∗
Long/short equity hedge 6074 2076 10051∗∗∗ 0083 0058 4027∗∗∗ 40086 33030 5028∗∗∗ 106061 48000 13081∗∗∗ 44010 31077 10058∗∗∗
Multistrategy 5067 2065 3055∗∗∗ 2038 0076 2044∗∗ 44069 40098 1005 106061 47018 5062∗∗∗ 38031 31056 2098∗∗∗
Commodity trading advisors 0060 0092 −0080 0071 0054 0067 10066 11054 −0062 31049 30063 0042 30039 28095 1060
All funds 5056 2080 11001∗∗∗ 1005 0079 3044∗∗∗ 40059 36073 3054∗∗∗ 96000 51045 15058∗∗∗ 40014 31024 12062∗∗∗
Panel C-2: Share restrictions (publicly traded funds only)
Lock-up period Minimum investment Redemption notice Redemption frequency Subscription

(days) ($mm) period (days) (days) frequency (days)
Publicly
traded funds Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat.
∗∗∗ ∗∗ ∗∗∗ ∗∗∗
Exchange listed 199 7905 4058 0082 0060 2044 47 33 4020 93 43 5003 35 30 2036∗∗
Hedgebay 276 14104 1067∗ 2016 1047 1021 69 54 1099∗∗ 98 83 0054 30 3205 −0079
traded
Notes. This table compares the characteristics of onshore and offshore funds. Reported numbers are sample averages across all funds within the same
investment style. Panel A displays fund size and age, and panel B presents fees and other fund characteristics. Panels C-1 and C-2 show share restriction
variables.
∗ ∗∗
, , and ∗∗∗ denote that the difference in the characteristics of onshore and offshore funds is significantly different from zero at the 10%, 5%, and 1%
levels, respectively.
onshore funds that are tradable on a secondary mar- Figure 2 Impact of the SEC Registration Rule on Lockups
ket (where the onshore funds clearly qualify as PTPs). 3.50
To address this concern, we compare share restrictions Onshore Vacation of the rule
Deadline
% of lockup ≥ 24 months
3.00
for two separate subsamples of tradable funds. The Offshore
first subsample includes all funds that are listed on 2.50
an exchange according to TASS. The second subsam- 2.00
ple corresponds to those funds with transactions on
Announcement
1.50
Hedgebay.com—a secondary market for hedge fund
shares.24 1.00
We first note that the proportion of onshore funds 0.50
among the exchange-listed (14%) and Hedgebay-
0.00
traded (23%) fund subsamples is much lower than 2003 2004 2005 2006 2007 2008 2009
that for the full sample (42%). This finding (not tab-
ulated) is consistent with Ramadorai (2012, 2013) and
the idea that onshore fund managers are more averse Lockup (months) (%)
to providing generous liquidity terms to investors No. of
because of PTP considerations. However, our main Time Domicile funds 0 401 125 12 4121 245 24 and up
interest is whether among the subsamples of traded Jan. 2003 Onshore 11141 6804 205 2800 0008 0099
funds, we still find greater share restrictions among Offshore 11531 8804 301 800 0005 0053
onshore funds. Table 2 compares share restrictions Jan. 2004 Onshore 11332 6303 306 3201 0006 0090
Offshore 11768 8601 303 907 0009 0086
of onshore and offshore funds for the two subsam-
Jan. 2005 Onshore 11519 6000 308 3501 0011 1000
ples of traded funds. Overall, we again find a signifi- Offshore 21144 8400 304 1104 0011 1012
cantly greater use of share restrictions among onshore Jan. 2006 Onshore 11770 5709 307 3605 0019 1063
funds. For example, differences in the lockup (199 Offshore 21712 8300 307 1109 0017 1017
versus 79.5 days) and redemption notice (47 versus Jan. 2007 Onshore 11947 5509 400 3703 0017 2066
Offshore 31039 8002 400 1400 0012 1060
33 days) are significant among exchange-listed funds.
Jan. 2008 Onshore 21116 5502 406 3702 0020 2077
Likewise, for Hedgebay-traded funds, the differences Offshore 31832 8001 403 1400 0016 1047
in lockup (276 versus 141.4) and redemption notice Jan. 2009 Onshore 21275 5602 407 3601 0019 2086
(69.3 versus. 54.1 days) are also significant. In light of Offshore 41808 8206 309 1200 0017 1044
this evidence, it is unlikely that the desire to avoid Notes. The new registration rule was announced in July 2004, and the dead-
PTP status can completely explain the greater use of line was February 1, 2006. On June 23, 2006, the rule was vacated by the
share restrictions among onshore funds. U.S. Court of Appeals.
Although our empirical design does not allow us
to separate the effects of regulations and tax cliente- To identify changes in funds’ use of share restric-
les on managers’ use of share restrictions, we exploit tions we use yearly snapshots of the TASS database
an exogenous change to the hedge fund adviser reg- around the announcement and subsequent reversal of
istration rule to demonstrate that the regulatory envi- the registration rule. In Figure 2 we show that the
ronment has a distinct effect on a fund’s decision to proportion of onshore funds with a lockup period of
impose a lockup. In December 2004, the SEC adopted at least two years increased from 1% to 3% between
a rule, subsequently overturned, that required all U.S. the announcement date (December 2004) and the date
hedge fund advisers with 14 or more clients, assets the rule was vacated (June 2006). This is consistent
of $25 million or higher, and with lockup periods less with at least some managers using lockups to circum-
than 2 years to register under the Investment Advisers vent registration. In contrast, the proportion of off-
Act by February 2006. The rule further required any shore funds with at least a two-year lockup did not
international advisers with at least 14 U.S. clients to increase as sharply (1% to 1.5%) over the same period.
register as well (Brown et al. 2008). As a consequence Therefore, we attribute the difference-in-difference in
of this rule, we expect the proportion of funds with a lockup frequency to the registration rule and con-
lockup of at least two years to rise over this period, clude that differences in regulation can impact share
and more so for onshore managers.25 restrictions.
Finally, we compare the share restrictions of master-
24
feeder (MF) pairs, which are defined as onshore and
We are grateful to Tarun Ramadorai for providing this informa-
tion for our sample of funds. See Ramadorai (2012) for a detailed
offshore funds offered by the same management firm.
description of the Hedgebay.com data. An MF structure is devised for hedge fund man-
25
The purpose of the two-year lockup exemption was to protect agers who wish to market a fund to both onshore
private equity and venture capital funds from registering with the and offshore investors. Instead of managing two dif-
SEC (see, e.g., Trombly 2006). ferent portfolios side by side, an MF manager usually
sets up one “master” company and several “feeders”: Table 3 Master-Feeder (MF) Funds
limited partnerships and offshore corporations for
Onshore Offshore t-stat.
onshore and offshore investors, respectively. The sole
investment of these feeders is an ownership interest Panel A: MF funds defined without the correlation
in the master, which is typically an offshore limited requirement (481 onshore/420 offshore funds)
liability company. The actual portfolio investment is Lock-up period (months) 5081 4047 2080∗∗∗
Redemption notice period (days) 44014 43011 0057
made at the master company level.26
Redemption frequency (days) 102029 68080 6011∗∗∗

We use the management company information pro- Subscription frequency (days) 36036 33031 4099∗∗∗
vided by TASS to identify MF funds. Specifically, if Management fee (%) 1032 1040 −2009∗∗
an onshore (offshore) fund has an offshore (onshore) Incentive fee (%) 19010 19062 −2015∗∗
counterpart that has the same investment style and Age (months) 119049 103089 4030∗∗∗
Average size ($mm) 137054 287072 −4089∗∗∗
management company, we classify that fund as an Eight-factor model alpha 0031 0029 0047
MF fund. In our sample, there are 481 onshore and (backfill adjusted, 1994–2008)
420 offshore funds that meet this MF fund crite- Asset illiquidity () 0019 0020 −0064
ria. We additionally consider the subsample of 257
onshore and 244 offshore MF funds that also hold the Panel B: MF funds defined with 0.99+ correlation
requirement (257 onshore/ 244 offshore funds)
same portfolio, indicated by a monthly return corre-
Lock-up period (months) 6006 5014 1040
lation of at least 0.99.27
Redemption notice period (days) 47066 46084 0036
Table 3 shows that the Share Restrictions Hypothe- Redemption frequency (days) 92025 70068 3029∗∗∗
sis holds for the subsample of MF pairs. For example, Subscription frequency (days) 36096 32064 2098∗∗∗
offshore funds allow redemptions once every 68.80 Management fee (%) 1036 1040 −0075
days versus 102.29 days for onshore funds. These Incentive fee (%) 19059 19075 −0065
Age (months) 109000 95040 3004∗∗
differences exist even among the subsample of MF Average size ($mm) 153078 306072 −3063∗∗∗
pairs with identical portfolios. We conclude that the Average return 0073 0066 1038
differences in share restrictions between onshore and (backfill adjusted, 1994–2010)
offshore funds cannot be fully explained by manager- Eight-factor model alpha 0027 0024 0062
specific or strategy-specific variables. (backfill adjusted, 1994–2008)
Asset Illiquidity (5 0021 0022 −0025
3.2. Asset Illiquidity Hypothesis Notes. This table compares share restrictions, asset illiquidity, risk-adjusted
In Table 4 we report the results from comparing performance, fee structure, age, and average asset size during the fund life of
onshore and offshore funds that belong to the MF structure. In panel A, an MF
market liquidity risk and asset illiquidity between
fund is defined as an onshore (offshore) fund that has an offshore (onshore)
onshore and offshore funds. We find that offshore counterpart that has the same management company and the same invest-
funds hold assets with both greater illiquidity and ment style within the full sample of 3,938 funds used in this paper. There are
higher market liquidity risk. For example, the Sadka 481 onshore funds and 420 offshore funds that meet the MF fund require-
(2006) liquidity beta is 0.55 for offshore funds on aver- ment in panel A. In panel B, a return correlation requirement is added to the
MF fund definition. That is, to be classified as an MF fund in panel B, the
age, as compared with 0.39 for onshore funds. A simi- onshore fund and the offshore fund have the same management company
lar, statistically significant pattern is also found when and the same investment style, and a high (0.99 or above) return correla-
measuring liquidity risk using the Pastor and Stam- tion. There are 257 onshore and 244 offshore funds that meet the more strict
baugh (2003) factor. In addition, we find that offshore definition of MF fund in panel B.
∗∗
and ∗∗∗ denote statistical significance at the 5% and 1% levels,
respectively.
26
To our knowledge, we are the first to exploit the master-feeder
structure to control for manager-specific effects in a comparison of
onshore and offshore funds. Aggarwal and Jorion (2010b) identify
funds hold assets with significantly greater illiquid-
master-feeder structures as part of a broader methodology to elim-
inate duplicate share classes offered by the same fund family. See ity as measured using the first-order return autocor-
Buscema (1996) and McCrary (2002) for a detailed description on relation of monthly fund returns. We reach the same
the master-feeder structure of hedge funds. conclusion when asset illiquidity is measured using
27
The number of funds is different across onshore and offshore the GLM (2004) measure, but the difference is not
MF funds because some offshore (onshore) funds have more than significant. As noted in our discussion above, the
one onshore (offshore) counterpart that has the same investment
company, same investment style, and the return correlation 0.99 or
greater use of share restrictions should mitigate the
higher. For example, Artemis Advisors registered two long/short need for onshore funds to hold more liquid assets.
equity hedge funds in 1998; one in British Virgin Islands and the Nevertheless, we can conclude from the evidence that,
other in Delaware. The two fund returns have a correlation coeffi- on balance, the opposing effects of share restrictions
cient of 0.9991. In 2000, they registered another long/short equity
hedge fund in Delaware and this new onshore fund return is also
on asset liquidity choice do not fully offset onshore
highly correlated to the offshore fund return (correlation coefficient: fund managers’ need to hold more liquid assets in
0.9963). anticipation of dealing with outflows.
Table 4 Illiquidity of Assets in Hedge Funds by Investment Style and by Domicile Country
Market illiquidity
Asset illiquidity
Pastor and Stambaugh (PS) (2003) Sadka (2006)
factor loading (PS 5 factor loading (Sadka 5 Autocorrelation () GLM (2004) measure ()
Investment style Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat.
Convertible arbitrage 0063 0036 0024 0046 0045 0005 0048 0046 0058 0039 0036 1021
Dedicated short seller −0017 −3083 1010 0054 0047 0013 0010 0014 −0080 0001 0003 −0016
Emerging markets 2035 3061 −0071 −0003 1016 −3047∗∗∗ 0019 0025 −1079∗ 0020 0023 −1016
Equity market neutral 2082 2068 0012 0064 0029 1074∗ 0011 0012 −0021 0005 0007 −0027
Event driven 3048 3049 −0001 0057 0066 −0086 0027 0025 0056 0025 0023 1041
Fixed income arbitrage 1033 2060 −0074 0032 0036 −0014 0034 0027 1042 0030 0020 2033∗∗
Global macro 2019 2046 −0014 0037 0074 −1037 0008 0008 0025 0001 0002 −0007
Long/short equity hedge 1028 3082 −3068∗∗∗ 0028 0036 −0071 0012 0014 −1028 0010 0010 −0040
Multistrategy 1015 3083 −2067∗∗∗ 0017 0055 −2010∗∗ 0024 0023 0037 0014 0019 −1019
Commodity trading advisors 4090 2000 1052 0055 0014 1014 0005 0006 −0060 −0011 −0024 0068
All funds 2008 3012 −2055∗∗ 0039 0055 −2021∗∗ 0017 0019 −3008∗∗∗ 0012 0013 −0058
All funds excluding 2007 3003 −2026∗∗ 0040 0043 −0033 0017 0018 −1070∗ 0011 0011 0030
emerging markets
Notes. This table compares offshore hedge funds with onshore funds in terms of market illiquidity beta and asset illiquidity measures. PS is the Pastor and
Stambaugh (2003) liquidity beta, Sadka is the Sadka (2006) liquidity beta, Autocorrelation () is the first-order serial correlation coefficient of fund return, and
GLM (2004) measure () is the illiquidity measure similar to that of Getmansky et al. (2004).
∗ ∗∗
, , and ∗∗∗ denote that the difference in the characteristics of offshore funds and onshore funds is significantly different from zero at the 10%, 5%, and
1% levels, respectively.
The style-by-style breakdown reveals that much restrictions and asset liquidity. Our discussion in §1
of the difference in asset liquidity can be traced to helps to reconcile these findings. In particular, dif-
the emerging markets category. However, Table 4 ferences in the regulatory environment and investor
shows that after excluding this category, we again find clienteles provide stronger motives for onshore funds
greater asset illiquidity and liquidity risk among off- to use share restrictions and hold liquid assets. Never-
shore funds, as measured by autocorrelation and the theless, we still expect hedge funds to use share
Pastor and Stambaugh (2003) factor loading. In addi- restrictions as a means to efficiently manage illiquid
tion, as noted above, we find (Table 1) that onshore asset holdings. Table 5 summarizes the results from
funds are encountered less frequently within style a multivariate logit analysis of the fund’s decision to
categories that prior literature views as “illiquid,”
such as emerging markets, convertible arbitrage, fixed Table 5 Logit Analysis of the Lockup Provision
income arbitrage, and multistrategy. This is consis-
All funds Onshore Offshore
tent with Brunnermeier and Pedersen’s (2009) predic-
tion that a hedge fund trader with relatively scarce Panel A: Univariate analysis with asset illiquidity
funding may be reluctant to hold “capital-intensive” Asset illiquidity () 0025∗∗∗ 0031∗∗∗ 0026∗∗∗
illiquid securities.28 Taken together, we interpret Pseudo-R2 (%) 7011 11008 4023
these results as support for the Asset Illiquidity Panel B: Univariate analysis with market illiquidity
Hypothesis—that is, offshore funds can manage asset Market illiquidity (Sadka ) 0001 0013∗ −0006
illiquidity better than their onshore counterparts can Pseudo-R2 (%) 6053 10043 3052
through easier issuance of new shares. In contrast, Panel C: Multivariate analysis
onshore funds cannot as easily reverse investor out- Asset illiquidity () 0029∗∗∗ 0030∗∗∗ 0030∗∗∗
flows by raising new capital, making it more costly Market illiquidity (Sadka ) −0002 0010 −0009
for these funds to hold illiquid assets. Age −0018∗∗∗ −0019∗∗∗ −0016∗∗
The above results show that compared with off- LP 1002∗∗∗ 0037∗∗ −0007
Pseudo-R2 (%) 11038 12016 4066
shore funds, onshore funds use more share restric-
tions yet hold more liquid assets. However, prior Notes. This table reports the parameter estimates and pseudo-R2 from the
studies find a strong negative relation between share logistic regression of lockup provision. Independent variables are asset illiq-
uidity (), market illiquidity (Sadka ), fund age, and a limited partnership (LP)
dummy variable. Investment style dummy variables are also included as con-
28
Aragon and Strahan (2012) attribute part of the drop in market trol variables. To make estimates comparable, variables are normalized to
liquidity following the Lehman Brothers bankruptcy to a drop in have a mean of 0 and a standard deviation of 1 across all funds.
∗ ∗∗
funding liquidity among hedge funds that used Lehman Brothers , , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% levels,
as their prime broker. respectively.
use a lockup provision. We estimate the model sepa- would have occurred if no new money had flowed in.
rately for the onshore and offshore fund subsamples. Consistent with prior studies, the top and bottom 1%
As explanatory variables we include asset illiquidity of the flows are winsorized to mitigate the effect of
(), liquidity risk factor loading (Sadka 5, fund age, and outliers.
an LP dummy. We also include investment style dum- In Panel A of Table 6 we compare the mean and
mies and normalize continuous variables to have a standard deviation of fund flows for onshore and off-
mean of 0 and a standard deviation of 1 across all shore funds by investment style. The mean flow is
funds. Consistent with the existing literature, we find slightly higher (but insignificant) for onshore funds
that both asset liquidity and fund age are negatively (2.68% versus 2.46% quarterly). Although the stan-
related to the use of lockups. This suggests that share dard deviation is much lower for onshore funds
restrictions allow funds to efficiently manage illiquid (15.74% versus 20.38%), the proportion of total vari-
assets (Aragon 2007), and younger funds use lockups ation in quarterly flows that is predictable is lower
to attract investors with low liquidity needs, thereby for onshore funds (8.16% versus 9.01% adjusted-R2 , in
avoiding adverse selection costs from raising external panel B).
capital (Lerner and Schoar 2004). These results hold Next, we run a piecewise linear regression of
for both the full sample (all funds) and the subsam- investor flows on relative performance variables Lowt ,
ples of onshore and offshore funds. Midt , and Hight . These variables are defined using
a fractional rank (FRANK) that represents a fund’s
3.3. Fund Flow Hypothesis percentile performance relative to other funds in
We use a methodology similar to Sirri and Tufano the same investment style during the previous year.
(1998) and Fung et al. (2008) to examine the flow- FRANK ranges from 0 to 1. The lowest performance
performance relationship. Specifically, we measure tercile (Lowt ) is defined as Min (1/3, FRANKt−1 );
capital flows into a fund during a quarter by using the middle performance tercile (Midt ) is defined as
the growth rate of net new money, which is defined Min (1/3, FRANKt−1 − Lowt ); and the highest per-
as Flowi1 t = (TNAi1 t − TNAi1 t−1 41 + Ri1 t 55/TNAi1 t−1 . formance tercile (Hight ) is defined as Min (1/3,
TNAi1 t is fund i’s total net assets at the end of quar- FRANKt−1 − Lowt − Midt ). For example, if a fund’s
ter t, and Ri1 t is the fund’s return during the quarter. FRANK was 0.82 last year, its Lowt is 1/3, Midt is
In other words, Flowi1 t represents the excess percent- 1/3, and Hight is 0.15. We include the logarithm
age growth of a fund during the quarter beyond what of the size in the previous period (Log(TNAt−1 )),
Table 6 The Effect of Performance on Capital Flows—Onshore vs. Offshore Hedge Funds
Panel A: Mean and standard deviation of quarterly flows
Cross-sectional average value of Cross-sectional average value of

average quarterly flow (%) standard deviation of quarterly flow (%)
Investment style Onshore Offshore t-stat. Onshore Offshore t-stat.
All funds 2.68 2.46 0.61 15.74 20.38 −10092∗∗∗
Panel B: The effect of performance on capital flows
Onshore Offshore Onshore–Offshore
Coefficient t-stat. Coefficient t-stat. Difference t-stat.
Intercept 000487 0088 001011 3009∗∗∗ −000524 −0082

Relative performance
Bottom performance tercile (Low) 002550 4073∗∗∗ 001702 3084∗∗∗ 000848 1021
Middle performance tercile (Mid) 000789 2083∗∗∗ 002037 6021∗∗∗ −001248 2090∗∗∗
Top performance tercile (High) 001285 3017∗∗∗ 002436 5093∗∗∗ −001151 1099∗∗
Std. dev. monthly returns −000071 −2001∗∗ −000089 −6049∗∗∗ 000018 0048
Log(TNAt−1 5 −000062 −1080∗ −000096 −6049∗∗∗ 000034 0091
Flow to the investment style 001079 4016∗∗∗ 001671 5011∗∗∗ −000592 −1042
High-water mark (HWM) 000102 2079∗∗∗ 000248 3042∗∗∗ −000146 −1080∗
dlock 000168 1036 −000009 −0014 000177 1029
Redemption 000005 0056 000053 1065 −000048 −1042
Subscription frequency −000068 −2072∗∗∗ 000041 0089 −000109 −2006∗∗
Management fee −000016 −0043 −000067 −1086∗ 000051 0098
Incentive fee 000000 −0003 −000002 −0085 000002 0045
Open to public 000242 2089∗∗∗ 000103 1021 000139 1016
Adjusted-R2 (%) 8016 9001
Table 6 (Continued)
Panel C: Effect of interaction between share restriction and performance
Onshore Offshore Difference
Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.
Intercept 000703 1059 000844 3002∗∗∗ −000141 −0027

Relative performance
Bottom performance tercile (Low) 001901 2022∗∗ 001633 2091∗∗∗ 000268 0026
Middle performance tercile (Mid) 001591 1053 002579 3074∗∗∗ −000988 −0079
Top performance tercile (High) 000411 0034 003187 6091∗∗∗ −002776 −2014∗∗
Performance/lockup interaction
Low ∗ dlock 000033 0004 001598 0060 −001565 −0056
Mid ∗ dlock 000415 0043 −002067 −1023 002482 1028
High ∗ dlock −000700 −1013 000069 0009 −000769 −0077
Performance/redemption interaction
Low ∗ Redemption 000165 0052 000021 0011 000144 0038
Mid ∗ Redemption −000213 −0081 −000255 −1023 000042 0013
High ∗ Redemption 000249 0086 −000231 −1090∗ 000480 1053
Dlock 000003 0002 000023 0005 −000020 −0004
Redemption −000024 −0035 000063 0093 −000087 −0091
Std. dev. monthly returns −000039 −5017∗∗∗ −000077 −7047∗∗∗ 000038 2099∗∗∗
Log(TNAt−1 ) −000083 −4007∗∗∗ −000094 −6095∗∗∗ 000011 0045
Flow to the investment style 001190 4078∗∗∗ 001709 4054∗∗∗ −000519 −1015
High-water mark (HWM) 000142 3022∗∗∗ 000339 5014∗∗∗ −000197 −2048∗∗
Subscription frequency −000054 −2045∗∗ 000088 2012∗∗ −000142 −3003∗∗∗
Management fee 000038 1018 −000054 −1041 000092 1085∗
Incentive fee 000001 0045 −000003 −0084 000004 0087
Open to public 000199 3045∗∗∗ −000001 −0002 000200 2036∗∗
Adjusted-R2 (%) 8013 9049
Notes. This table presents quarterly capital flows to hedge funds. Similar to Sirri and Tufano (1998) and Fung et al. (2008), quarterly flows are measured
by using the growth rate of net new money, which is defined as Flowi1 t = (TNAi1 t − TNAi1 t−1 ∗ 41 + Ri1 t 55/TNAi1 t−1 . TNAi1 t is fund i’s total net assets at the
end of quarter t, and Ri1 t is the fund’s return during the quarter. Panel A compares onshore and offshore funds in terms of mean and standard deviation
of quarterly flows. Panel B presents the effect of relative performance on capital flows to onshore and offshore funds. Panel C tests the effect of interaction
between performance and share restriction. In panel B, the coefficient estimates are presented from the piecewise linear regression of investor flows on
relative performance variables, Low, Mid, and High. These variables are defined using a fractional rank (FRANK) that represents a fund’s percentile performance
relative to other funds in the same investment style during the previous year. FRANK ranges from 0 to 1. The lowest performance tercile (Lowt ) is defined as
Min (1/3, FRANKt−1 5, the middle performance tercile (Midt ,) is defined as Min (1/3, FRANKt−1 − Low t ), and the highest performance tercile (Hight ) is defined
as Min (1/3, FRANKt−1 − Low t − Mid t ). For example, if a fund’s FRANKt−1 is 0.88, its Lowt is 0.33, its Midt is 0.33, and its Hight is 0.22. As control variables,
risk, size, flows to the investment style, lockup dummy (dlock), redemption notice period plus redemption frequency (Redemption), subscription frequency,
fees, high-water mark (HWM) dummy, and open-to-public dummy variables are included. Panel C includes the interaction of share restrictions such as dlock
and Redemption with the performance tercile. The regressions are run quarterly, and standard errors and t-statistics are calculated from the quarterly results
as in Fama and MacBeth (1973).
∗ ∗∗
, , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% levels, respectively.
standard deviation of fund returns, flows to the onshore funds leads to an increase in net flows of only
investment style, share restrictions, fees, high-water 0.8%. The difference in coefficients is significant. We
mark (HWM) dummy, leverage dummy, and open-to- also find significantly lower flow/performance sensi-
public dummy variables as control variables. We con- tivity among onshore funds in the top performance
duct the regressions quarterly during 1994–2010 and tercile (High). This pattern holds only for the middle
calculate the Fama and MacBeth (1973) coefficients as and top performance terciles. In fact, conditional on
well as the t-statistics. the bottom quintile of performance, we find that the
In panel B of Table 6 we report the results from flow/performance sensitivity is actually stronger for
estimating the piecewise linear regression of investor onshore funds, though the difference is not significant
flows on relative performance. We find that the sen- (t = 1021).29 Overall, our findings support the Fund
sitivity of net fund flows to past performance, espe- Flow Hypothesis.
cially stronger performance, is greater for offshore
funds. For example, a change in rank from the 50th 29
We find similar results when we group performance into the bot-
percentile to the 60th percentile increases net flows by tom, middle three, and top performance rank quintiles. We also
2.0% for offshore funds, and the increase is significant tested whether the coefficients on Low, Mid, and High are equal and
at the 1%level. However, the same jump in rank in rejected these linearity restrictions.
The evidence in panel B of Table 6 is also con- cant at the 1% level.31 In addition, the higher average
sistent with Getmansky et al. (2011). They find that return and Sharpe ratio among onshore funds is very
hedge funds exhibit a concave flow-performance rela- stable across style categories.32
tion in the presence of share restrictions, but a con- Next, we compare the eight-factor model alphas of
vex relation in the absence of restrictions (similar to onshore and offshore funds for the full sample period
mutual funds). Their results point to both a direct and two subperiods (1994–2001 and 2002–2008). The
results, summarized in panel B of Table 7, show that
effect of the binding restrictions and an indirect effect

from investors endogenizing expected future binding onshore funds significantly outperform offshore funds
restrictions. Indeed, in our comparison of onshore and during the earlier period. In particular, the difference
in risk-adjusted returns is 33 basis points per month.
offshore funds, we find that the flow-performance
However, we find virtually no difference in perfor-
relation is convex among offshore funds, where share
mance during the full and latter sample periods. Over-
restrictions are used relatively lightly.
all, we find some evidence in support for the Fund Per-
One concern is that a reduced flow-response to formance Hypothesis, that onshore funds outperform
past performance among onshore funds can result offshore funds, depending on the sample period.33
mechanically from their greater use of share restric- Panel C of Table 7 compares fund performance after
tions rather than from a greater regulatory burden further subdividing the sample based on whether a
that makes it difficult to raise new capital (i.e., our fund has a lockup provision. We find a positive and
Fund Flow Hypothesis). To address this issue, we significant differential between the performance of
first note that the differences in flow-response that onshore and offshore funds that do not have a lockup
we observe correspond to the middle and top ter- provision (t = 1087). On the other hand, there is no
ciles of performance, whereas redemption restrictions significant difference in performance among the two
plausibly have a stronger effect on flows follow- segments when a lockup provision exists (t = −1063).
ing poor performance. More directly, however, we In addition, the “lockup premium”—the performance
include interactions of share restrictions and perfor- differential between the lockup funds and nonlockup
mance variables in the flow-performance regression. funds—is −0.04% for onshore funds and 0.13% for
We can therefore interpret the coefficients on the key offshore funds. That offshore funds earn a positive
performance rank variables as the estimated flow- lockup premium is consistent with our findings that
performance sensitivities conditional on funds with offshore funds have greater asset illiquidity and liq-
uidity risk (from Table 4).
no lockups and zero redemption notice periods. The
Our earlier results highlight significant differences
results (Table 6, panel C) again show a reduced sensi-
between onshore and offshore funds in the degree of
tivity of investor flows to the middle and top perfor-
share restrictions, asset liquidity, and market liquid-
mance terciles among onshore funds and significantly ity risk, which have been found to have significant
so for performance in the top tercile. This indicates explanatory power for hedge fund returns based on
that share restrictions alone cannot explain the lower prior research.34 Therefore, we next compare the per-
sensitivity of onshore fund flows to performance in formance of onshore and offshore funds after further
the middle and top quintiles.30 controlling for differences in market liquidity, share
3.4. Fund Performance Hypothesis 31

Underperformance of offshore funds is also consistent with a
Panel A of Table 7 reports the average, standard devi- negative relation between performance and operational risk, as in
Brown et al. (2008, 2009), since offshore funds face less regulatory
ation, and Sharpe ratio of monthly returns for onshore scrutiny.
and offshore funds over the period 1994–2010. We 32
The onshore/offshore average return spread is positive for all
find that onshore funds generally have higher aver- styles except for convertible arbitrage.
age returns and higher Sharpe ratio than do offshore 33
For robustness, we use the robust bootstrap methodology devel-
funds. For example, the average monthly return of oped by Kosowski et al. (2006) and confirm that the outperfor-
onshore funds is 0.74%, as compared with just 0.63% mance of onshore funds during the earlier sample period cannot be
attributed to pure luck. A detailed description of the bootstrap anal-
for offshore funds. This 0.11% monthly spread (1.32% ysis is available from the authors upon request. Also, see Kosowski
annualized) between the two fund groups is signifi- et al. (2007) and Fung et al. (2008) for further applications of a
bootstrap analysis to hedge fund performance.
34
A positive relation between fund returns and share restrictions,
30
We also find very similar results when we compare the flow vari- like lockups and notice periods, is reported by Liang (1999), Bali
ability and the flow-performance relation of onshore and offshore et al. (2007), Liang and Park (2007), and Aragon (2007). More
funds that do not have a lockup provision. This provides further recently, Sadka (2010) finds that funds loading significantly on liq-
support for our conclusion that the patterns we observe in flows uidity risk subsequently outperform low-loading funds by about
are not driven by differences in share restrictions. 8% annually over the period 1994–2007.
Table 7 Performance and Risk of Onshore and Offshore Hedge Funds
Panel A: Risk and return
Average return (%) Standard deviation (%) Sharpe ratio
Investment style Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat.
Convertible arbitrage 0043 0055 −1060 2055 2063 −0024 0036 0018 0091
Dedicated short seller 0021 0010 0053 6020 5088 0025 0003 0000 0096
Emerging markets 0098 0077 1057 6020 6005 0027 0011 0013 −0098
Equity market neutral 0048 0038 1024 3001 2034 1075∗ 0014 0011 0081
Event driven 0071 0054 2080∗∗∗ 3011 2064 2000∗∗ 0021 0017 1042
Fixed income arbitrage 0069 0036 2058∗∗ 2059 2088 −0066 1003 0023 1066
Global macro 0083 0058 1066∗ 3079 3086 −0020 0018 0012 1061
Long/short equity hedge 0073 0068 1032 4099 4046 2079∗∗∗ 0013 0013 −0026
Multistrategy 0077 0057 2080∗∗∗ 3029 3060 −0094 0024 0017 2024∗∗
Commodity trading advisors 0089 0073 1064 5092 5036 1025 0010 0012 −0080
All funds 0074 0063 3083∗∗∗ 4042 4020 1086∗ 0018 0015 2001∗∗
Panel B: Eight-factor model alpha
1994–2001 2002–2008 1994–2008
Investment style Onshore Offshore t-stat. Onshore Offshore t-stat. Onshore Offshore t-stat.
Convertible arbitrage 0025 0046 −1025 −0003 0002 −0070 0001 0012 −1069∗
Dedicated short seller 0047 0052 −0008 0008 0014 −0019 0012 0031 −0070
Emerging markets 0013 0009 0010 0052 0042 0068 0042 0035 0050
Equity market neutral 0065 0050 0063 0014 0025 −1012 0018 0025 −0073
Event driven 0043 0026 1001 0021 0011 1023 0022 0012 1042
Fixed income arbitrage 0052 0010 2037∗∗ 0015 0005 0078 0028 0008 1070∗
Global macro 0082 −0025 3023∗∗∗ 0044 0026 1007 0049 0013 2009∗∗
Long/short equity hedge 0092 0075 1004 0021 0028 −1033 0027 0033 1018
Multistrategy 0097 0029 1082∗ 0032 0029 0040 0038 0030 1008
Commodity trading advisors 0004 −0062 2022∗∗ 0083 0071 0076 0068 0045 1047
All funds 0063 0030 3046∗∗∗ 0029 0029 0000 0032 0029 1001
Panel C: Performance of onshore vs. offshore hedge funds by lockup periods
Lockup Nonlockup
Number Eight-factor Number Eight-factor Difference
(percent) model alpha (percent) model alpha (lockup − nonlockup 5
All funds 931 (31.7%) 0033 21008 (68.3%) 0028 0005

Onshore funds 555 (45.2%) 0029 674 (54.8%) 0034 −0004
Offshore funds 376 (22.0%) 0038 11334 (78.0%) 0025 0013∗∗∗
Difference 4onshore − offshore 5 −0009 0009∗
Panel D: Performance-size regression
1994–2001 2002–2008 1994–2008
Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.

∗∗
Intercept only 003507 2059 −000251 −0044 001617 2018∗∗
Intercept 000080 0003 −004887 −1046 −002032 −1029
AUM difference −005005 −1076∗ −007453 −1040 −005585 −2062∗∗∗
Adjusted-R2 2051 1015 3040
Notes. Panels A and B compare the risk, return, and risk-adjusted performance of onshore and offshore funds. The sample period for estimating average
return, standard deviation, and Sharpe ratio is January 1994–December 2010, and the reported numbers are sample averages. To adjust for the backfill bias,
we deleted all fund returns before the date when the fund was added to TASS. The sample period for estimating the eight-factor model alpha is January 1994–
December 2008. Panel C lists a two-way sorting result to compare the eight-factor model alpha: (i) onshore versus offshore, (ii) lockup versus nonlockup.
Panel D presents a time-series regression to test the relation between performance and size. The dependent variable is the difference in the cross-sectional
average return (onshore–offshore), and the independent variable is the difference in the log of cross-sectional average AUM (onshore–offshore).
∗ ∗∗
, , and ∗∗∗ denote that the difference is significantly different from zero at the 10%, 5%, and 1% levels, respectively.
Table 8 Liquidity-Adjusted Alpha
Sample period du dlock du · dlock Redemption MinInv AUM Adjusted-R2
1994–2008 0004 0094

(entire period) 410095
0001 0009 0001 0037 −0009 1040
400295 420075∗∗ 400295 410705∗ 4−30345∗∗∗
0007 0017 −0016 0001 0035 −0009 1051

410395 420905∗∗∗ 4−20035∗∗ 400245 410615 4−30345∗∗∗
0001 0015 −0014 0003 0054 −0007 −0008 2022
400115 420465∗∗ 4−10705∗ 410655∗ 420395∗∗ 4−20735∗∗∗ 4−30845∗∗∗
1994–2001 0025 11000
(before the 420495∗∗
rapid growth) 0020 0036 0002 0007 0002 12018
410885∗ 420585∗∗∗ 400375 410545 400325
0025 0053 −0035 0002 0008 0002 12030
420225∗∗ 420755∗∗∗ 4−10295 400305 410625 400415
0026 0055 −0041 0003 0010 0002 −0005 13005
420175∗∗ 420745∗∗∗ 4−10435 400625 410835∗ 400425 4−00935
2002–2008 0001 2083
(rapid growth 400315
followed by the −0002 0010 0000 0002 −0008 3049
financial crisis) 4−00395 420405∗∗ 400115 410285 4−30875∗∗∗
0002 0015 −0009 0000 0002 −0008 3049
400355 420515∗∗ 4−10115 400145 410225 4−30865∗∗∗
−0007 0011 −0005 0003 0004 −0007 −0009 4089
4−10255 410785∗ 4−00535 410515 420235∗∗ 4−30225∗∗∗ 4−40335∗∗∗
Notes. This table presents the parameter estimates and adjusted-R2 s from the cross-sectional regression of ˆ i = 0 + 1 dui + 2 dlock i + 3 dui · dlock i + 4 ·
Redemptioni + 5 · MinInv i + 6 · i + 7 AUM + style dummies + i . The dependent variable is a fund’s eight-factor model alpha (i ). Explanatory variables
are onshore dummy (du), lockup dummy (dlock), the interaction between onshore dummy and lockup dummy (du · dlock), redemption notice period plus
redemption frequency (Redemption), minimum investment amount (MinInv), asset illiquidity (), log of assets under management at the beginning of the
sample period (AUM), and style dummy variables. To make parameter estimates comparable, continuous explanatory variables are normalized to have a mean
of 0 and a standard deviation of 1. t-statistics are reported in parentheses.
∗ ∗∗
, , and ∗∗∗ represent statistical significance at the 10%, 5%, and 1% levels, respectively.
liquidity, and asset liquidity. Our “liquidity-adjusted onshore funds outperform offshore funds during
alpha” is estimated using a two-step procedure. First, the earlier half of our sample. In particular, during
we conduct a time-series regression with the excess 1994–2001, the liquidity-adjusted alpha of onshore
return of a hedge fund as the dependent variable and funds is 0.26% per month higher than offshore
the seven factors of Fung and Hsieh (2004) plus the funds. However, over the latter part of our sample
market liquidity factor of Sadka (2006) as explanatory period (2002–2008) we do not find a significant dif-
variables to estimate eight-factor model alphas (ˆ i ). ference in performance. Our results also show pos-
Then we run a cross-sectional regression of ˆ i on itive coefficients on the share restrictions variables
asset illiquidity (), share restriction variables as in and are therefore consistent with prior findings of a
Equation (1), and an onshore dummy variable (du). share illiquidity premium in hedge fund returns. For
Finally, we include the natural logarithm of fund example, the higher returns attributable to fund lock-
AUM as a separate explanatory variable in the per- ups, or “lockup premium,” is positive and significant
formance regressions. Since this is a single cross- for both the earlier and latter halves of our sample
sectional regression, we are careful to measure AUM period (0.36% and 0.10%, respectively).35
at the beginning of the period over which perfor-
mance is calculated. We estimate 35
One concern (raised by a referee) is that the merger of Tremont
into TASS during 1999–2001 introduced inaccuracies in the TASS
ˆ i = 0 + 1 dui + 2 dlock i + 3 dui · dlock i data fields (e.g., lockup period) for the pre-merger Tremont funds
now in TASS. Our finding of a significant lockup premium dur-
+ 4 redemptioni + 5 MinInvi + 6 i ing both 1994–2001 and 2002–2010 suggests that data inaccuracies
cannot fully explain the lockup effect. We also identify Tremont
+ 7 AUMi + style dummies + i 1 (1)
funds following Aggarwal and Jorion (2010a) and repeat our main
tests after excluding these funds. We find that the eight-factor alpha
where du · dlock measures the marginal effect on the
over the full sample is significantly higher (0.18% monthly) among
lockup premium of being domiciled onshore. funds with lockup provisions and that, consistent with the Share
The results are reported in Table 8. Overall, our Restrictions Hypothesis, the lockup period is significantly higher
main finding here is consistent with Table 7—that among onshore funds (5.88 versus 2.85 months).
Fung et al. (2008) find that because of decreasing onshore funds outperform offshore funds, but only
returns to scale, high-alpha funds have lower future during the earlier part of our sample period. We con-
alphas. Evidence of decreasing returns to scale is clude that the constraints faced by onshore managers
also apparent from our results. First, onshore funds in growing fund assets do not appear to have a cost,
outperform only during the first half of our sam- at least over the full sample period, in terms of hav-
ple, corresponding broadly to the period before the ing to share rents with fund investors in the form of
industry’s rapid growth. Second, the coefficient on greater after-fee returns.
AUM is negative in all subperiods and significantly A better understanding of the differences between
so during the latter (2002–2008) and the full sample onshore and offshore funds may shed light on the
period. Third, in panel D of Table 7 we present the impact of current U.S. hedge fund regulation. To the
results from regressing the monthly return differen- extent that new legislation under the Dodd–Frank
tial between onshore and offshore funds against the Act places a comparatively greater regulatory bur-
corresponding monthly differential in AUM. When den on onshore fund managers, this may increase
we run the intercept-only regression that excludes the the incentives for managers to circumvent regulation
AUM variable, we find that the average return differ- by opening offshore funds. Our results suggest that
ential between onshore and offshore funds is positive the impact of such legislation on fund liquidity (e.g.,
and significant for both the 1994–2001 and 1994–2008 lockup periods) and asset liquidity should be consid-
periods. However, the intercept becomes insignificant ered from a policy perspective.
when we control for the difference in average fund
AUM between the two fund groups. This is explained Acknowledgments
by the negative and significant coefficient of AUM Previous versions of this paper were circulated under the
variable. We draw two conclusions from this: one, title “Share Restrictions, Liquidity Premium, and Offshore
greater relative fund size diminishes the relative per- Hedge Funds.” The authors are grateful for comments from
formance of onshore funds; two, when the average Turan Bali, Arnoud Boot, Stephen Brown, Tom Fraser, Mila
size of offshore and onshore funds is the same, we Getmansky, Hossein Kazemi, Bernard Morzuch, Joseph
find no significant difference in performance. Reising, Tom Schneeweis, Clemens Sialm, Paula Tkac, and
Mingming Zhou; from participants at the 2007 Financial
Overall, any constraints faced by onshore man-
Management Association Annual Meeting, the 2007 China
agers in growing fund assets do not appear, at least
International Conference in Finance, the Center for Inter-
over the full sample period, to result in a sharing of national Securities and Derivatives Markets 2007 Annual
rents with investors (in the form of greater after-fee Research Conference, the 2008 Financial Intermediation
returns). Also, any motives of onshore fund managers Research Society Conference, and the 2011 Korea Capital
to achieve greater tax efficiency do not seem to place Market Institute and Korea America Finance Association
significant constraints on investment strategies, which Conference; and from the seminar participants at the Uni-
would be reflected by lower risk-adjusted returns. versity of Amsterdam, Binghamton University, Koç Univer-
sity, University of Massachusetts Amherst, and Minnesota
State University, Mankato. The authors are responsible for
4. Conclusion any errors.
We undertake a comprehensive analysis of onshore
and offshore hedge funds to study the effects of fund
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Onshore and Offshore Hedge Funds: Are They Twins?

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Onshore and Offshore Hedge Funds:

1. Introduction regulatory concerns.3 They also have access to capital

AUM (US$ billion)

constraints on investment strategies, which would be 200

Table 1 Legal Structure of Hedge Funds by Domicile Country

Legal structure (%)

Panel A: Size and age

Total AUM ($ billion)

Panel B: Fees and other characteristics

Panel C-1: Share restrictions (all funds)

Panel C-2: Share restrictions (publicly traded funds only)

Lock-up period Minimum investment Redemption notice Redemption frequency Subscription

Redemption frequency (days) 102029 68080 6011∗∗∗

Panel A: Mean and standard deviation of quarterly flows

Cross-sectional average value of Cross-sectional average value of

Investment style Onshore Offshore t-stat. Onshore Offshore t-stat.

All funds 2.68 2.46 0.61 15.74 20.38 −10092∗∗∗

Panel B: The effect of performance on capital flows

Onshore Offshore Onshore–Offshore

Coefficient t-stat. Coefficient t-stat. Difference t-stat.

Intercept 000487 0088 001011 3009∗∗∗ −000524 −0082

Panel C: Effect of interaction between share restriction and performance

Onshore Offshore Difference

Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.

Intercept 000703 1059 000844 3002∗∗∗ −000141 −0027

effect of the binding restrictions and an indirect effect

3.4. Fund Performance Hypothesis 31

Table 7 Performance and Risk of Onshore and Offshore Hedge Funds

Panel A: Risk and return

Average return (%) Standard deviation (%) Sharpe ratio

Panel B: Eight-factor model alpha

1994–2001 2002–2008 1994–2008

Panel C: Performance of onshore vs. offshore hedge funds by lockup periods

All funds 931 (31.7%) 0033 21008 (68.3%) 0028 0005

Panel D: Performance-size regression

1994–2001 2002–2008 1994–2008

Coefficient t-stat. Coefficient t-stat. Coefficient t-stat.

Table 8 Liquidity-Adjusted Alpha

Sample period du dlock du · dlock Redemption MinInv  AUM Adjusted-R2

1994–2008 0004 0094

0007 0017 −0016 0001 0035 −0009 1051

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Sample period du dlock du · dlock Redemption MinInv AUM Adjusted-R2