Flows, performance, and managerial incentives in hedge funds

Agarwal, V, Daniel, N D and Naik, N (2004) Flows, performance, and managerial incentives in hedge funds. Working Paper. London Business School Centre for Hedge Fund Research and Education Working Paper.

Abstract

Using a comprehensive database of hedge funds, we investigate two important issues. First, we examine the determits of moneyflows into hedge funds. In particular, we investigate how moneyflows relate to past performance, managerial incentives, impediments to capital withdrawals, and past moneyflows. Second, we analyze how future performance relates to fund size, past flows, managerial incentives, and impediments to withdrawals. For this purpose, we use a novel approach to model the incentivefee contract of hedge fund managers as a portfolio of call options. In this framework, the delta of this option portfolio captures the managerial incentives. We have several new and interesting findings. First, funds with good recent performance experience larger moneyflows and this performanceflow relation is convex. Also, funds with higher delta, lower impediments to withdrawals, and greater past flows experience higher moneyflows. Second, we find that larger funds with greater inflows are associated with poorer future performance, a result consistent with decreasing returns to scale. Also, funds with higher delta and greater impediments to capital withdrawals are associated with superior future performance. Overall, these results significantly improve our understanding of determits of moneyflows, nature of managerial incentives, behavior of investors, and drivers of performance in hedge funds.