hedge strongfundsstrong performance, risk, and capital formation.pdf

THE JOURNAL OF FINANCE • VOL. LXIII, NO. 4 • AUGUST 2008 Hedge Funds: Performance, Risk, and Capital Formation WILLIAM FUNG, DAVID A. HSIEH, NARAYAN Y. NAIK, and TARUN RAMADORAI∗ ABSTRACT We use a comprehensive data set of funds-of-funds to investigate performance, risk, and capital formation in the hedge fund industry from 1995 to 2004. While the average fund-of-funds delivers alpha only in the period between October 1998 and March 2000, a subset of funds-of-funds consistently delivers alpha. The alpha-producing funds are not as likely to liquidate as those that do not deliver alpha, and experience far greater and steadier capital inflows than their less fortunate counterparts. These capital inflows attenuate the ability of the alpha producers to continue to deliver alpha in the future. HEDGE FUNDS ARE LIGHTLY REGULATED active investment vehicles with great trad- ing flexibility. They are believed to pursue highly sophisticated investment strategies, and promise to deliver returns to their investors that are unaffected by the vagaries of financial markets. The assets managed by hedge funds have grown substantially over the past decade, increasingly driven by portfolio al- locations from institutional investors.1 Hedge funds have also been attracting attention from academics, who have recently documented several interesting facts. First, a large proportion of the variation in hedge fund returns can be explained by market-related factors (see, for example, Fung and Hsieh (1997, 2001, 2002, 2004a, 2004b), Agarwal and Naik (2004), and Hasanhodzic and Lo (2006)).2 This suggests that hedge fund fees (which are often substantial fractions of the total returns earned by funds, not their alphas) provide com- pensation for taking on