The Reasons Behind Declines In Hedge Fund Alpha
The “unscalability” of hedge fund managers’ acumen appears to be a major reason that the average risk-adjusted return (alpha) of hedge funds declines over time, new research shows.
A recent working paper by a researcher at Penn State examined the declining alpha the hedge fund sector has suffered over the past fifteen years.
One of the study’s main findings refutes the notion that average hedge fund alpha has declined due to the creation of a number of inferior hedge funds: “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.
(Chart displays the difference between “Top” and “Bottom” funds (95th
percentile minus 5th percentile; 90th percentile minus 10th percentile; 75th percentile minus 25th percentile). The sample period extends from January 1994 through December 2005. )
The two main reasons cited for the decline in alpha are the change in fund characteristics and market conditions.
Unsurprisingly the paper finds that “hedge fund investors chase alpha at the individual fund level, thus funds with large positive alphas receive more flow than those with negative alphas.” However, flow into the strategy to which a fund belongs always has a negative impact on the fund’s future performance.
Lastly, “Our findings indicate that the decline in alpha over time is attributable to capacity constraints, which arise both from the unscalability of managers’ abilities and from the limited profitable opportunities in the market. Therefore, hedge fund investors should consider the capacity constraints at both fund level and strategy level, before making the decision to chase alpha.”
∗Why Does Hedge Fund Alpha Decrease over Time? Evidence from Individual Hedge Funds (Zhaodong( Ken) Zhong, Smeal College of Business, Penn State University). Via Kedrosky.
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