Why Does Hedge Fund Alpha Decrease Over Time? Evidence from Individual Hedge Funds

Abstract

Why has the aggregate level of hedge fund alpha (risk-adjusted return) decreased over time? We find that the decrease in alpha is not due to an increasing percentage of funds with unskilled managers. Instead, it is due to a decrease in the proportion of funds capable of producing large positive alphas, which is consistent with the capacity constraint hypothesis. Using quantile regression and counter-factual density analysis, we show that a change in fund characteristics combined with a change in market conditions contributes to the decrease in the proportion of funds with positive alphas. Furthermore, we find that fund-level flow has a positive (negative) impact on a fund's future performance for smaller (larger) funds, while strategy-level flow has a negative impact on the fund's future performance. Our results suggest that the economic reasons for capacity constraints arise both from the "unscalability'' of managers' abilities and from the limited profitable opportunities in the market.

Keywords: hedge funds, performance, alpha, flows, capacity constraints, counter-factual analysis

JEL Classification: G11, G12, G23