Flows, Price Pressure, And Hedge Fund Returns by Katja Ahoniemi and Petri Jylha
Abstract
The authors studied how capital flows affect hedge fund returns and found that funds with high inflows outperform funds with high outflows during the month of the flows. This immediate reaction, combined with feedback trading, gives rise to a cycle: Flows exert price pressure, this effect on returns induces more flows, and these flows cause further price pressure. The cycle is so strong that it takes two years for a full return reversal, and it contributes to the observed persistence in hedge fund performance. The impact of flows on returns has clear implications for performance evaluation: One-third of estimated hedge fund alphas are due to flows.
Flows, Price Pressure, And Hedge Fund Returns – Introduction
Over the past two decades, hedge funds have experienced large inflows of capital. The academic literature shows that fund flows result in an uninformed demand shift, which may affect asset prices. In this study, we examined the effect that capital flows have on hedge fund returns. Our results are consistent with a mechanism whereby funds respond to flows by scaling their portfolios up or down, rather than diversifying. These trades have a contemporaneous price impact on the funds’ underlying assets, leading to an effect on fund-level returns. Reversal of the initial flow-induced price pressure is delayed by the price impact exerted by further performance-chasing flows. Our results are similar to those of Lou (2012), who studied mutual fund flows.
The existing literature on uninformed demand shocks has mainly focused on studying equity benchmark index redefinitions (Shleifer 1986; Harris and Gurel 1986; Greenwood 2005) and the flow-driven trading of mutual funds in US equities (Coval and Stafford 2007; Chen, Hanson, Hong, and Stein 2008; Frazzini and Lamont 2008; Greenwood and Thesmar 2011; Khan, Kogan, and Serafeim 2012; Lou 2012). In particular, the latter group of studies examined capital flows in and out of mutual funds and investigated the price impacts of the flows on the stocks held by the funds. Compared with these studies, the use of hedge fund data allowed us to examine the flow-related phenomena with a much broader set of underlying assets and investment strategies, including the use of leverage and derivatives. The fact that our results are consistently present across various
types of hedge funds shows that flow-induced price pressure is not limited to only equities.1 Also, hedge funds are able to hold more illiquid portfolios than mutual funds owing to lockup periods. Further, the sequential nature of flows and returns—monthly flows are submitted before the concurrent return is known, which is not the case for mutual funds-
allowed us to quantify the contemporaneous effect that flows have on fund-level returns and hedge fund performance attribution.
- Discussion of findings. We arrived at four key findings. First, hedge fund returns exhibit statistically and economically significant flow-induced price pressure: Funds that received high inflows outperformed funds that experienced large outflows during the month of the flows. Second, over the subsequent months, reversal of the initial price impact occurs relatively slowly: On average, full reversal took around 24 months. Third, flow induced price pressure contributes to the observed persistence in hedge fund returns. Fourth, and maybe most interestingly from a practitioner’s point of view, flows have implications for performance attribution: Estimated hedge fund alphas fell by 33% when controlling for flow impacts. These results contribute to the existing literature on flow-induced price pressure as well as to the hedge fund literature. In the next section, we review the related literature and how our results link to and extend this body of research.
Literature Review
The first main finding is that capital flows have a contemporaneous effect on hedge fund returns: Funds with large inflows outperform funds with large outflows during the month of the flows. This effect is present in calendar-time portfolios sorted on flows, in fund-level time-series regressions, and in cross-sectional regressions. After sorting hedge funds into five flow portfolios, the high-flow funds outperformed the low-flow funds by 0.96% per month. This result indicates that hedge fund flows are large enough in relation to the liquidity of the underlying assets for flows to have a significant price impact. We argue that the contemporaneous causality runs from flows to returns. First, this is the usual assumption in the literature.2 Second, Edelen and Warner (2001) studied daily aggregate mutual fund flows and, using intraday stock index data, established that the positive contemporaneous relation between flows and returns arises because flows cause returns. Third, and most importantly, hedge funds are particularly well suited for this choice of causality because lengthy notification periods, infrequent trading, and delays in return reporting all but guarantee that investors are required to submit their subscriptions and redemptions before learning about the contemporaneous returns.
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