Hedge Funds: Performance, Risk and Capital Formation

By: Wiliam Fung, London Business School; David Hsieh, Duke University; Narayan Y. Naik, London Business School; Tarun Ramadorai, University of Oxford
Published: July 16, 2006
This paper analyses funds of hedge funds and has been widely circulated due to its conclusion that hedge fund alpha is shrinking.  But it also contains a number of other important observations.

For example, high alpha producing funds of funds attract new capital in a consistent manner – regardless of recent past performance:

“…funds that produce alpha receive far greater inflows of capital than funds that only exhibit factor exposures. The capital flows into the alpha producing funds are steady, and do not significantly respond to recent past returns, while the flows into the remaining funds are characterized by return-chasing behavior.”

The paper also argues that excessive capital inflows lead to lower returns.  This “capacity effect” has been percolating around the industry for several years.  (But other research has shown that too many assets do not necessarily reduce returns.) 

Finally, the paper suggests that managers who produce only (exotic) beta will be forced to lower their fees:

“Funds that do not produce alpha may be tempted to lower their fees to compete with those who do. In other words, we believe that the apparent differences in the ability of the two groups of funds (alpha producers and the rest) to attract investor capital will ultimately manifest itself in the differential pricing of services offered by these two groups of funds.”

There are at least two ways we can think of to achieve such “differential pricing” for hedge funds.  One is to simply charge for true alpha (although, as we have discussed, alpha may just be beta we haven’t managed to commoditize yet).  Thus, if 30% of a fund’s return was pure alpha, the manager would only charge a performance fee on that 30% (the rest would be charged at a low rate structured as a management fee so the manager does not benefit from a rising tide).  If prices were set this way, the blended fee would be higher for a manager who produced more alpha and lower for a manager who produced less. 

The second way to differentiate pricing would be to charge different prices for different elements of return ranging from pure alpha to pure beta.  In between would be higher pricing for more exotic species of “hedge fund” beta and lower prices for forms of beta such as ETFs of major indices.  While this may be unworkable in practice, it does raise the intriguing question: is there a supply curve for beta?… 

“Our findings suggest that there is an apparent mismatch between the supply and demand for alpha. On the one hand, capital appears to be seeking alpha. On the other hand, the supply of alpha appears to be drying up. We believe that the divergent ability to attract capital between the alpha producing funds and their less fortunate counterparts will ultimately translate into a revision of the hedge fund contract. Funds that fail to produce alpha may be tempted to lower their fees in order to attract investors’ capital. This would result in different prices for the services offered by these two groups of funds.”

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