By: Andrea Beltratti, Bocconi University & Claudio Morana, ICER & Michigan State University
Published: October 1, 2006

Remember that kid on your block who used to get kicks out of handing you a garden hose on a hot summer day, then cranking the faucet to “full” in an attempt to squeeze the insides of your head out your eye-sockets?  If any of your friends were able to withstand that torrent of water without getting sick, call them up.  Ten bucks says they’re managing a hedge fund now.  According to a recent study, increasing torrents of money into hedge funds don’t lead to lead to sickly returns.

Prevailing wisdom seems to suggest that hedge fund alpha will eventually drown in a deluge of new assets.  But this study finds that the impact of asset inflows is not a significant detractor of hedge fund alpha.

“…our results are not consistent with the view of a decline in the excess returns produced by the hedge funds industry: the impact of flows is not so strong to obscure the relevance of other factors which maintain open opportunities for hedge funds to perform profitable strategies. Hence, our results do not support the view according to which an excess supply of arbitrage capital exhausts the set of available opportunities.”

But how can this be?   Intuition suggests that more assets chasing the same inefficiency will eventually arbitrage- (“iron”) out that inefficiency.  As Alexander Ineichen says in his new book, the market “learns” or “becomes immune” to the arbitrageur (although he does say that markets cannot be perfectly efficient).  But according to Beltratti and Morana, market participants have heterogeneous utility functions (a notion also argued by Max Darnell, Joanne Hill, and William Sharpe):

“The wide variety of real world investors, including noise traders and investors with heterogeneous time horizons and objectives, seems to provide plenty of opportunities for hedge funds managers to exploit: the limits of arbitrage do not seem to have been met yet.”

So hedge fund alpha seems to be able to withstand an onslaught of new capital in the long-run (or at least from 1994-2005).  But what about sudden waves of new capital?  What if a hedge fund strategy experienced a sudden flood of new money over the course of a quarter?  Beltratti and Morana find that nearly all strategies have been able to withstand sudden pops in AUM without an accompanying drop in returns:

“…(asset) flows determine a small portion of the variability of excess returns…r-squared attributable to past flows are small, i.e. 23% for convertible arbitrage, 0.1% for fixed income arbitrage and 22% for long short equity. Only in the case of event driven the figure is as large as 73%. Therefore, only in the case of Event Driven hedge funds there is strong impact of the variability of flows on the variability of excess returns…”

It makes intuitive sense that strategies with a very defined opportunity set (mergers, for example) would experience an “ironing-out” of potential alpha quickly with a flood of new assets – and the authors provide compelling evidence of this.  Another explanation we have heard is that it is harder to put new assets to work in less liquid strategies, leading to larger cash balances and lower subsequent returns simply because of the temporarily large denominator.

In any case, this research suggests we are always discovering new deposits of alpha around the world and that asset inflows have yet to exhaust these sources.

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