Abstract

http://ssrn.com/abstract=1108817
 
 

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Why Does Hedge Fund Alpha Decrease Over Time? Evidence from Individual Hedge Funds


Zhaodong Zhong


Rutgers University

January 2008


Abstract:     
Why has the aggregate level of hedge fund alpha (risk-adjusted return) decreased over the last decade? By studying the distribution of individual hedge fund alphas, we find that the large right tail (funds with positive alphas) that was once present has shrunk over time, while the left tail (funds with negative alphas) has remained unchanged. Thus, the decrease in average alpha is not due to an increasing percentage of funds with unskilled managers and negative alphas, as suggested by the hedge fund bubble hypothesis. Instead, it is due to a decrease in the proportion of funds capable of producing large positive alphas. Our evidence is consistent with the prediction of the capacity constraint hypothesis. Using quantile regression and counter-factual density analysis, we show that a change in fund characteristics combined with a change in market conditions contributes to the decrease in the proportion of funds with positive alphas. Furthermore, we find that fund-level flow has a positive (negative) impact on a fund's future performance for smaller (larger) funds, while strategy-level flow (flow into the strategy to which a fund belongs) always has a negative impact on the fund's future performance. Our results suggest that the economic reasons for capacity constraints arise both from the "unscalability" of managers' abilities and from the limited profitable opportunities in the market.

Number of Pages in PDF File: 53

Keywords: hedge funds, performance, alpha, flows, capacity constraints, counter-factual analysis

JEL Classification: G11, G12, G23

working papers series


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Date posted: March 25, 2008  

Suggested Citation

Zhong, Zhaodong, Why Does Hedge Fund Alpha Decrease Over Time? Evidence from Individual Hedge Funds (January 2008). Available at SSRN: http://ssrn.com/abstract=1108817 or http://dx.doi.org/10.2139/ssrn.1108817

Contact Information

Zhaodong Zhong (Contact Author)
Rutgers University ( email )
Department of Finance, Rutgers Business School
94 Rockafeller Road
Piscataway, NJ 08854-8054
United States
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