Study hints that alpha may be finite (at least in the short term)

CAPM / Alpha Theory 14 Jun 2009

As the hedge fund industry smashed through the one trillion dollar level a few years ago, it became vogue to ponder whether the new assets would dilute existing alpha opportunities.  Was alpha a finite resource that needed to be shared among an ever growing number of industry players?  And if so, was the hedge fund industry destined to become a victim of its own success because managers, like chickens, become less productive as they become too crowded?

Research seemed to indicate that average alpha was indeed on the decline as the industry grew.  But many also argued that the industry was being diluted by “unskilled” new entrants.

But if the new entrants were really “unskilled”, their effect on the returns of the incumbents should be minimal.  If a group of 200 “skilled” managers were joined by 5,000 dart-throwing monkeys, then the original 200 should arguably be able to maintain their aggregate alpha.  The simian stock-picking efforts of the monkeys should cancel themselves out.

So what really is the effect of new entrants on the alpha of the incumbents?  And perhaps more importantly given the recent industry shrinkage, what will be the effects of removing players from the competitive landscape?

An academic study released in February revisits the relationship between alpha and industry-wide AUM.  In “Crowded Chickens Farm Fewer Eggs” Oliver Weidenmuller and Marno Verbeek of the Rotterdam School of Management theorize what has led to the slow decline in hedge fund alpha earlier this decade (depicted in the chart below from their study).

The authors also wonder if this is a result of each individual fund being overwhelmed by new assets (commonly associated with lower returns) or if a finite amount of alpha simply had to be divided among an ever-growing field of competitors.

First, they find that new entrants in the hedge fund industry may not be “unskilled” at all.  In fact, new entrants over the 2000-2006 period actually produced more alpha than the supposedly superior incumbents…

Ergo, the introduction of skilled entrants into a sector does, in fact, decrease the average alpha generated – at least in the short term.  Observe the authors:

“It appears as any additional inflows in strategy segment decrease obtainable alpha returns, and that there is a maximum level of capital allocated to a strategy segment beyond which the performance of all funds suffers.”

And the negative effect of such crowding is not limited to funds with a negative return.  According to this study, both “winners” and “losers” suffer when the chicken coop gets too crowded.

And what about the effect of inflows on individual funds?  Weidenmuller and Verbeek find that inflows do have a negative effect on smaller funds.  But when funds become large, the drag of excessive inflows is swamped by the fact that the fund is simply too large to produce great returns.

The paper examined data predating the hedge fund industry “rightsizing” of the past year and is dated February 19, 2009.  So we will be very curious to see if the opposite is true:  that as strategy-wide AUM figures drop, returns bounce back.  If April, May and the post-LTCM period (in the first chart above) are any indication, the findings may apply in both directions?

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