Flows, performance, and managerial incentives in hedge funds

Finance

Centre for Hedge Fund Research and Education Working Paper

Agarwal V;Daniel N D;Naik N Y

Narayan Naik

2004

Using a comprehensive database of hedge funds, we investigate two important issues. First, we examine the determinants of money-flows into hedge funds. In particular, we investigate how money-flows relate to past performance, managerial incentives, impediments to capital withdrawals, and past money-flows. Second, we analyze how future performance relates to fund size, past flows, managerial incentives, and impediments to withdrawals. For this purpose, we use a novel approach to model the incentive-fee contract of hedge fund managers as a portfolio of call options. In this framework, the delta of this option portfolio captures the managerial incentives. We have several new and interesting findings. First, funds with good recent performance experience larger money-flows and this performance-flow relation is convex. Also, funds with higher delta, lower impediments to withdrawals, and greater past flows experience higher money-flows. Second, we find that larger funds with greater inflows are associated with poorer future performance, a result consistent with decreasing returns to scale. Also, funds with higher delta and greater impediments to capital withdrawals are associated with superior future performance. Overall, these results significantly improve our understanding of determinants of money-flows, nature of managerial incentives, behavior of investors, and drivers of performance in hedge funds.

Institute of Finance and Accounting, Hedge Fund Centre

HF-016

Centre for Hedge Fund Research and Education Working Paper

No