No hedge fund bubble…but a potentially serious capacity constraint

Date: Tuesday, April 1, 2008
Author: All About Alpha

From Several studies over the past few years have suggested that the much heralded “hedge fund alpha” is declining. These studies have examined average hedge fund performance (overall, or funds within a specific strategy). As a result, they have been unable to differentiate between two possible causes of the decline: an increase in the number of unskilled managers who generate negative alpha and a decrease in the number of hot-shots who produce large alphas (essentially, the skew of the hedge fund return distribution).

This is kind of ironic given that the industry seems to obsess over the “non-normality” of hedge fund returns. While fund and sub-strategy returns may be non-normal, there often seems to be an implicit assumption that alphas follow a bell curve. Thus, when hedge funds underperform, we assume that all hedge funds underperform - that the bell curve simply shifted to the left.

But Zhaodong Zhong of Penn State University wondered if the averages hide a more complex explanation. His new study examines the performance of individual hedge funds to determine if average hedge fund alpha has fallen a) due to more unskilled managers (the “hedge fund bubble” hypothesis) or due to less superstars (the “capacity constraint” hypothesis)... Full article: