Hedge Funds: Performance, Risk and Capital Formation

Abstract:     
We use a comprehensive dataset of funds-of-funds to investigate performance, risk and capital formation in the hedge fund industry over the decade from 1995-2004. We first confirm that there are high systematic risk exposures in the returns of funds-of-funds in our data. We then divide up the ten years into three distinct sub-periods and demonstrate that the average fund-of-funds has only delivered alpha in the short second period from October 1998 to March 2000. In the cross-section, however, we are able to identify funds-of-funds capable of delivering alpha. We find that these alpha producing funds-of-funds experience far greater and steadier capital inflows than their less fortunate counterparts. In turn, these capital inflows adversely affect their ability to produce alpha in the future. These findings strongly support Berk and Green's (2004) rational model of active portfolio management, in which diminishing returns to scale combined with the inflow of new capital into better performing funds leads to the erosion of superior performance over time.

Keywords: hedge funds, funds-of-funds, performance, alpha, factor models, flows, capacity constraints

JEL Classifications: G11, G12, G23

Working Paper Series