Impact of Size and Flows on Performance for Funds of Hedge Funds

Abstract

After studying the impact of fund size and fund flows on the subsequent performance of funds of hedge funds, the authors find that funds with more assets tend to produce higher returns at lower levels of volatility, resulting in superior risk-adjusted performance. Across the majority of the size spectrum, a positive concave relationship exists between fund asset size and performance, while a negative correlation relationship exists between asset size and standard deviation. The smallest 25% of funds of funds underperformed the largest 75% of funds of funds by more than 2% annually from January 1995 to November 2006.This performance differential arises because a higher portion of the smallest funds deliver lower alpha, causing them to subsequently fail. Past good performers attract new inflows,but strong inflows adversely affect the subsequent performance of previously top-performing funds. In contrast, the top-performing and largest funds with below average asset flows perform significantly better than top funds with above average flows.