Capacity constraints and hedge fund strategy returns

Naik, N, Ramadorai, T and Stromqvist, M (2006) Capacity constraints and hedge fund strategy returns. Working Paper. London Business School BNP Paribas Hedge Fund Centre Working Paper Series.

Abstract

Hedge funds have generated significant absolute returns (alpha) in the decade between 1995 and 2004. However, the level of alpha has declined substantially over this period. We investigate whether capacity constraints at the level of hedge fund strategies have been responsible for this decline. For four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha, consistent with this hypothesis. We also find evidence that hedge fund fees have increased over the same period. Our results provide support for the Berk and Green (2004) rational model of active portfolio management.