Hedge Funds: Performance, Risk, and Capital Formation
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What they found
Using funds of hedge funds from 1995 to 2004 to avoid the biases in single-fund databases, the authors found that only about 20% of funds delivered statistically significant alpha, and that alpha-producing funds were more likely to persist, attracted much larger capital inflows, and then experienced declining alpha as the money arrived, consistent with capacity constraints. The average fund's returns were mostly explained by exposures to a set of risk factors (equity, bonds, credit, trend-following) rather than by skill.
What you can use
- Most hedge fund returns are explained by exposure to known risk factors; genuine alpha was found in a minority of funds.
- The funds that did have alpha saw it shrink as they grew, which is Berk and Green's capacity argument in the data.
- Trend-following exposure is a major component of hedge fund returns, which is why replicating it cheaply matters.
Caveats
Funds of funds add a layer of fees and selection; the risk-factor model is the authors' construction. Sample ends 2004.
Tags: professional, hedge-funds, alpha, capacity
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.