European Financial Management

European Financial Management, Vol. 13, No. 2, 2007, 239–256

Capacity Constraints and Hedge Fund

Strategy Returns

Narayan Y. Naik

BNP Paribas Hedge Fund Centre, London Business School, London, NW1 4SA, UK

E-mail: nnaik@london.edu

Tarun Ramadorai

Sa¨d Business School, Oxford University and CEPR, Park End Street Oxford OX1 1HP, UK

ı

E-mail: tarun.ramadorai@sbs.ox.ac.uk.

Maria Stromqvist

Department of Finance, Stockholm School of Economics, Box 6501, 113 83 Stockholm, Sweden

E-mail: maria.stromqvist@hhs.se

Abstract

Hedge funds have generated significant absolute returns (alpha) in the decade

between 1995 and 2004. However, the level of alpha has declined substantially

over this period. We investigate whether capacity constraints at the level of hedge

fund strategies have been responsible for this decline. For four out of eight hedge

fund strategies, capital inflows have statistically preceded negative movements in

alpha, consistent with this hypothesis. We also find evidence that hedge fund fees

have increased over the same period. Our results provide support for the Berk

and Green (2004) rational model of active portfolio management.

Keywords: Hedge funds; capacity constraints; alpha; factor models; performance

fees; flows

JEL classification: G11, G12, G23

1. Introduction

Hedge funds display many of the features of the ‘arbitrageurs’ referred to in canonical

formulations of the efficient markets hypothesis. These large, relatively unregulated,

highly sophisticated investors are thought to represent a strong disciplining force

We are grateful to Bill Fung, David Hsieh, Mila Getmansky, Bing Liang, an anonymous

referee and participants at the European Financial Management Association meetings and

London Business School for their constructive comments and suggestions. We are thankful

for financial support from Inquire UK and from the BNP Paribas Hedge Fund Centre at

the London Business School. This research was conducted...