CAPM alpha explains hedge fund flows better than alphas from more sophisticated models. This suggests that investors pool together sophisticated model alpha with returns from exposures to traditional (except for the market) and exotic risks. We decompose performance into traditional and exotic risk components and find that while investors chase both components, they place greater relative emphasis on returns associated with exotic risk exposures that can only be obtained through hedge funds. However, we find little evidence of persistence in performance from traditional or exotic risks, which cautions against investors’ practice of seeking out risk exposures following periods of recent success.
While traditionally all returns unrelated to the market have been interpreted as manager skill (alpha), investors have begun to recognize the return implications of other traditional risks (such as size and value) as well as more exotic risks (such as momentum and option-like investments) generally only available through hedge funds.
We begin our empirical analysis by conducting a flow-performance horse race to infer which risk model hedge fund investors use when allocating capital.
Consistent with the argument that portfolio disclosure reveals "trade secrets", a difference-in-differences estimation suggests that there is a drop in fund performance after a hedge fund begins filing Form 13F, as well as an increase in return correlations with other funds in the same investment style.
The drop in performance is concentrated among funds with larger expected proprietary costs of disclosure — for instance, funds that disclose a greater fraction of their assets or hold more illiquid stocks. The drop in performance cannot be fully explained by alternative explanations such as decreasing returns to scale or mean reversion in fund returns.
We use a unique data set of hedge fund long equity and equity option positions to investigate a significant lockup-related premium earned during the Tech Bubble and Financial Crisis.
Net fund flows are significantly greater among lockup funds during crisis and non-crisis periods.
Managers of hedge funds with locked up capital trade opportunistically against flow-motivated trades of non-lockup managers, consistent with a hypothesis of rent extraction in providing crisis era liquidity.
The success of this opportunistic trading is concentrated during periods of high borrowing costs, in less liquid stock markets, and is enhanced by hedging in the equity option market.