Net Inflows and Time-Varying Alphas: The Case of Hedge Funds
Jan 8th, 2007 | Filed under: Hedge Fund Industry TrendsBy: 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):
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