| Why has the aggregate level of hedge fund alpha (risk-adjusted return) decreased over the last decade? By studying the distribution of individual hedge fund alphas, we find that the large right tail (the percentage of funds with positive alphas) that was once present has shrunk over time, while the left tail (the percentage of funds with negative alphas) has remained unchanged. Thus, the decrease in average alpha is not due to an increasing proportion of funds with unskilled managers and negative alphas, as the hedge fund bubble hypothesis suggests. Instead, it is due to a decrease in the proportion of funds that are capable of producing large positive alphas. Our evidence is consistent with the predictions of the capacity constraint hypothesis. Using quantile regression and counter-factual density analysis, we show that both the changes in fund characteristics and the changes in market conditions from the 1990s to the 2000s contribute to the decrease in the proportion of funds with positive alphas. Furthermore, we find that fund-level flow has a positive (negative) impact on a fund's future performance for smaller (larger) funds, while strategy-level flow (flow into the strategy to which a fund belongs) always has a negative impact on the fund's future performance. Our results suggest that the economic reasons for capacity constraints arise both from the "unscalability" of managers' abilities and from the limited profitable opportunities in the market. |
