Hedge funds: performance, risk and capital formation

Fung, W and Naik, N (2006) Hedge funds: performance, risk and capital formation. Working Paper. London Business School BNP Paribas Hedge Fund Centre Working Paper Series.

Abstract

We use a comprehensive dataset of FundsofFunds (FoFs) to investigate performance, risk and capital formation in the hedge fund industry over the past ten years. We confirm the finding of high systematic risk exposures in FoF returns. We divide up the past ten years into three distinct subperiods and demonstrate that the average FoF has only delivered alpha in the short second period from October 1998 to March 2000. In the crosssection of FoFs, however, we are able to identify FoFs capable of delivering persistent alpha. We find that these more successful hedge funds experience far greater (and steadier) capital inflows than their less fortunate counterparts. Berk and Green's 2004 rational model of active portfolio management implies that diminishing returns to scale combined with the inflow of new capital leads to the erosion of superior performance over time. In keeping with this implication, we provide evidence that even successful hedge funds have experienced a recent, dramatic decline in riskadjusted performance.