The Search for Alpha: Have All the Low Hanging Fruits Been Picked? Empirical Evidence from Long/Short Equity Hedge Funds

Abstract

The Assets under Management of Hedge Funds have increased substantially, according to estimates from HFR from $ 237 Billion in 2000 to $ 2 940 Billion in 2015. At the same time hedge fund performance declined from over 10% per annum before 2000 to below 6% in the new millennium. According to the assumptions of Hsieh and Fung, alpha returns per dollar invested will decrease as long as the supply of alpha is finite. In case the market is dominated by alpha seekers instead of beta chasers, the growth of the hedge fund industry is destined to end. The current development is also consistent with the prediction of Berk and Green (2004) that capital-inflows will ultimately erode performance due to diminishing returns of scale and alpha producing funds decay to beta-only funds over time. Investors are already demanding alternatives, such as low-cost passive indexes or clones, which replicate beta-returns by providing systematic risk exposure to conventional asset-class factors. Besides the ideas for new trading strategies and hedge fund products to generate beta-returns, alpha-returns are, if at all, not easily replicated. Therefore it is necessary to research what kind of returns investors really want and if the increase in assets directly or indirectly causes alpha-returns to diminish. This paper provides empirical evidence on the return-chasing behavior of investors and the existence of long-term performance persistence of hedge fund returns. Additionally the correlation and causal relationship between asset-growth and alpha-returns of Long/Short Equity hedge fund indexes and single hedge funds is examined.