Flows, Price Pressure, and Hedge Fund Returns

Abstract

O ver 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 performancechasing 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 fundsallowed 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, flowinduced 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 R...

Impact of investor attention on mutual funds.

“…Such findings in Tables 5 and 6—price elevation in a short term, followed by reversal—are consistent with the results on American stock market (Da et al, 2011; Kim & Meschke, 2014), hedge funds (Ahoniemi & Jylhä, 2014), and mutual funds (Lou, 2012). Generally, performance reversal in stock market occurs in a relatively short time frame (from days to weeks), but it occurs over a much longer period (quarters) as documented in the “smart money” effect in mutual funds (Gruber, 1996; Zheng, 1999).…”

“…Generally, performance reversal in stock market occurs in a relatively short time frame (from days to weeks), but it occurs over a much longer period (quarters) as documented in the “smart money” effect in mutual funds (Gruber, 1996; Zheng, 1999). Ahoniemi and Jylhä (2014) report that in hedge funds the cycle of mutual promotion between flows and price pressure is so strong that it takes 2 years for a full return reversal. Lou (2012) finds that flow-induced trading positively forecasts mutual fund returns in the following year, which are then reversed in subsequent years.…”

Does institutional ownership predict mutual fund performance? An examination of undiscovered holdings within 13(f) reports

“…For instance, Gruber () and Zheng () show that funds that receive greater net money inflows subsequently outperform their less popular peers (i.e., the ‘smart money’ effect). Ahoniemi and Jylhä () find that one third of hedge fund alphas are due to hedge fund flows and this relationship reverses after 2 years . Our results so far reveal that the relationship between institutional ownership and subsequent mutual fund performance is not driven by fund flows.…”