Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers

Skin or Skim? Inside Investment and Hedge Fund Performance

“…Our key contribution is to document how hedge fund managers prioritize personal investments to less-scalable strategies, and subsequently restrict the scale of their funds, in ways that boost performance. This result connects closely with Yin (2016), who emphasizes the role of decreasing returns to scale among hedge funds, which managers seem not to fully internalize given their stated contract terms including management and performance fees. We document that a non-stated contract term and the presence of insider capital provides an important additional reason for fund managers to operate their funds at smaller scales.…”

“…When choosing where to allocate personal capital, managers internalize the fact that raising additional capital dilutes the fund's return due to decreasing returns to scale. Previous papers assessing decreasing returns to scale include: Yin (2016), Ramadorai (2013), Getmansky (2012), and Teo (2009). As a result, our model predicts that managers will invest their capital in their least-scalable strategies, and that they will operate these funds with greater insider capital at a smaller scale by restricting the entry of outside investors.…”

“…We test the relationship between excess returns and scalability of the hedge fund, following Yin (2016):…”

“…2 We also test the relationship between inside investment and fund scalability. Following the methodology employed by Yin (2016), which measures the decreasing return to scale by regressing style-adjusted returns against lagged assets, we find that funds with greater insider investment are also less scalable.…”

The Performance of Hedge Fund Performance Fees

“…negatively related to future fund performance (Fung, Hsieh, Naik, and Ramadorai, 2008;Teo, 2009;Yin, 2016). Indeed, we confirm that return-chasing investors do not appear to achieve superior performance.…”