The Convexity and Concavity of the Flow-Performance Relationship for Hedge Funds
47 Pages Posted: 5 Oct 2013
Date Written: March 15, 2013
The shape of the flow-performance relationship in the hedge fund industry is not constant over time, but varies across market conditions. We employ a switching regression approach to explain quarterly hedge fund flows, based on two regimes where either inflows or outflows are dominating, combined with a flexible functional form for each of the equations, allowing for a nonlinear impact of past performance at different lags. For most periods, the flow-performance relationship is locally convex for a large subset of funds but becoming concave for the top three deciles of performers. The kink in the top part is more pronounced when aggregate inflows to the industry are high. This effect seems mostly driven by funds that restrict new inflows, for example due to capacity constraints or decreasing returns to scale. These results are helpful in understanding the incentives of hedge fund managers based on both performance fees and management fees.
Keywords: hedge funds, flow-performance relation, convexity, concavity, liquidity restrictions, managerial incentives
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