The Effect of Investor Flows on Hedge Fund Manager Performance and the Decision to Invest

Abstract

The Hedge Fund Industry has grown tremendously over the last decade and a half and its importance is becoming more pronounced in the financial markets. This thesis examines if manager performance is driving the growth of hedge funds, and how the performance of the funds is affected by increasing investor flows. Using data on the monthly returns of 3668 hedge funds during the period January 1988 to December 2005, from a less frequently researched hedge fund database, CISDM, individual hedge fund alphas are estimated using an eight-factor model. It is found that manager alphas have compressed towards zero over time and investors are generally not likely to find managers who generate significant risk adjusted returns annually and persistently. Using a logistic regression, the determinants and influences on alpha and persistence are explored. It is found that managers increase their likelihood of having alpha and their likelihood of persistence in alpha by taking on less risk, as well as age tends to negatively affect alpha. Lastly, the relationship of investor flows to performance is examined. Investors are found to be rational because flows do not react to alpha, since most managers are unlikely to generate alpha persistently. Investors do however, base their flows on past raw returns and generally prefer funds with low volatility and more experience.