A First Cut Evaluation of the Impact of Industry Cash Flows on Hedge Fund Alpha

Abstract

The current consensus that industry growth, as evidenced by massive cash flows and the proliferation of hedge funds, must lead to substantially lower returns across the wide spectrum of strategies clearly has both some intuitive attractiveness and some academic support. Yet only a more careful analysis can help determine whether it is really valid in practice or simply too sweeping to contain useful insights. In this brief article, the author summarizes work recently completed to address this issue in some more depth. A first cut analysis of manager alpha across several strategies or groups of strategies does suggest that there may have been more negative impact from cash flows in the absolute return space than in the area of semi-directional or managed futures strategies. This makes general sense when one observes that there are more conceivable limits to the number of trading opportunities available in the absolute return space than in other segments of the hedge fund industry. Yet even there, one should recognize that this analysis has identified interesting alpha trends, but has not focused on explaining them in an exhaustive and systematic manner. It would therefore be very interesting to conduct additional research, focused first on a more detailed definition of manager alpha and second on the explanation of changes in these levels of alpha, when these have evidently occurred.