Share Restrictions and Investor Flows in the Hedge Fund Industry

Abstract

We study the effect of share restrictions on the fund flow-performance relation of individual hedge funds. With a simple model, we demonstrate that restrictions, which represent short options positions for fund investors, significantly change the shape of the flow-performance relation in the lower and middle regions. Consistent with the predictions of our model, our empirical results show that an increase in share restrictions such as a subscription period, redemption period, advance notice period, lockup period, onshore domicile, whether a fund belongs to a capacity constrained style or is open to public lead to an increasingly inverted S-shaped fund flow-performance relation. Surprisingly, similar to mutual funds, hedge funds exhibit a convex flow-performance relation in the absence of these share restrictions. Our evidence is consistent with investors rationally endogenizing expected future binding restrictions when investing (or disinvesting) their money. We also present evidence that reconciles past empirical work on the hedge fund flow-performance relation.