Home Bias and Local Contagion: Evidence from Funds of Hedge Funds

This paper analyzes hedge fund investors’ geographical preference and its implication for hedge fund performance. We document that funds of funds overweigh their investments in hedge funds located in the same cities by 6 to 15 percent. We also find that funds of funds with a stronger local bias exhibit superior performance. However, this local bias of funds of funds can adversely impact the hedge funds by creating excess comovement and local contagion. We find excessive comovement in investor flows among local hedge funds. Moreover, we provide evidence that large outflows of local funds of funds increase local contagion, since hedge funds located in the same area are more likely to experience distress at the same time. Overall, our results suggest that while local funds of funds benefit from local informational advantages, their local bias creates market segmentation that could destabilize financial markets. JEL classification: G01, G11, G23