Several studies over the past few years have suggested that the much heralded “hedge fund alpha” is declining. These studies have examined average hedge fund performance (overall, or funds within a specific strategy). As a result, they have been unable to differentiate between two possible causes of the decline: an increase in the number of unskilled managers who generate negative alpha and a decrease in the number of hot-shots who produce large alphas (essentially, the skew of the hedge fund return distribution).
This is kind of ironic given that the industry seems to obsess over the “non-normality” of hedge fund returns. While fund and sub-strategy returns may be non-normal, there often seems to be an implicit assumption that alphas follow a bell curve. Thus, when hedge funds underperform, we assume that all hedge funds underperform – that the bell curve simply shifted to the left.
But Zhaodong Zhong of Penn State University wondered if the averages hide a more complex explanation. His new study examines the performance of individual hedge funds to determine if average hedge fund alpha has fallen a) due to more unskilled managers (the “hedge fund bubble” hypothesis) or due to less superstars (the “capacity constraint” hypothesis). (Hat tip to blogger Paul Kedrosky for bringing this paper to our attention).
Zhong’s conclusion is that the apparent secular decrease in hedge fund alpha during the past decade was a result of less hot-shots (i.e. a thinner right tail in the distribution), not a result of more unskilled managers entering the industry (i.e. a fatter left tail in the distribution). To put it in the lexicon of quants, he essentially finds that the positive skew and the excess kurtosis of hedge fund returns have decreased. To put it in everyday terms, there are fewer George Soros’ breaking the Bank of England these days and making a billion dollars in the process.
As you can see from the charts above, the proportion of funds producing monthly alpha’s above around 50 bps has decreased markedly from the mid-1990’s to the middle of this decade. Meanwhile, the proportion of funds producing around 0 alpha has increased dramatically. Curiously, the proportion of funds producing alphas below -50bps per month has remained about the same. In other words, there are as many losers in the industry today as there were back in the 90’s. This is proof, says Zhong, that the “hedge fund bubble” hypothesis is wrong.
So it seems the hedge fund industry may be “capacity constrained” after all. But is this due to a glut of assets flowing into each strategy (causing all of its remaining arbitrage opportunities to disappear), or is it the result of a glut of assets flowing into individual funds (requiring managers to focus on lower quality ideas in an effort to put the money to work)? As Zhong points out, studies of the average hedge fund can’t answer this question.
By studying 8000 individual funds, he concludes that when a hedge fund sub-strategy experiences a large net inflow of assets, it is more likely to outperform – suggesting a capacity constraint on the strategy level.
He also finds that inflows to funds with previously high alphas tend to cause alpha to go down. This is not the case for inflows into funds with alphas that were previously not that high. This suggests that there exists some sort of capacity constraint at the fund level as well. (Although increasing flows into the smallest funds had an opposite effect – increasing alpha – suggesting smaller funds can absorb asset inflows more easily.)
So how much of the shortage of alpha-generators is a result of funds simply growing too large? After all, the average hedge fund was a lot bigger in 2005 than it was in 1995. Perhaps that is the reason for the decline in alpha.
To answer this “apples-to-oranges” concern, Zhong compares funds of a similar size and characteristics in both time periods.
The blue line in the chart above shows how the 90s-type funds performed in the 2003-2005 period – an “apples-to-apples” comparison across time. As you can see, the ultimate performance of 2003-2005’s funds is partially explained by a tougher alpha-generating environment, but is also explained by something else (namely, the fact that funds are a lot bigger these days).
Zhong also examined whether hedge fund investors were performance chasers. His results corroborated earlier studies that suggested hedge fund investors love a hot fund. Interestingly, though, he also finds that performance chasing at the strategy-level is more pronounced that performance chasing within a strategy.
If there is any good news here for hedge fund managers, its that decreasing alpha is correlated not so much with the absolute size of funds or strategies, but with the recent asset flows into funds or strategies. This suggests that the rapid growth of the hedge fund industry, not its absolute size, may be at the heart of the declining alpha phenomenon. Further, as you might expect, asset flows into directional strategies such as emerging markets strategies are less harmful to alpha than asset flows into arbitrage strategies (where opportunities disappear as they are exploited).
Finally, Zhong also funds that asset flows into funds with high management fees tend to decrease alpha while asset flows into funds with high performance fees tend to actually increase alpha. Go figure.
A lot changed between 1994-1996 and 2003-2005 that may have decreased the number of high alpha producers in the hedge fund industry. But whatever the factors causing this change, one thing is clear: institutions focus on alpha more than traditional hedge fund investors ever did. As Zhong points out:
“…funds with large positive alphas receive more [asset] flow than those with negative alphas. This is consistent with the increasing emphasis on alpha by institutional investors who have overtaken wealthy individuals as the primary hedge fund investors.”