WHAT DRIVES HEDGE FUND FLOWS?

Question 1

What did the authors find regarding the risk model most used by investors for capital allocation?

Answer 1

The authors found that investors predominantly use CAPM for capital allocation decisions, even more so than simply relying on raw returns. This implies a strong reliance on CAPM among hedge fund investors.

Question 2

How do investors respond to different components of hedge fund returns, according to the study?

Answer 2

Investors respond to all three components of hedge fund returns, including alpha, traditional risk factors, and exotic risk factors. However, there is a larger emphasis on exotic factors, indicating that investors credit hedge fund managers for their ability to generate returns from exotic risk exposures.

Question 3

What implications did the study draw regarding the persistence of factor returns in hedge funds?

Answer 3

The study found no persistence in factor returns, but it did find evidence of risk exposure (beta) persistence. This suggests that while hedge funds maintain consistent risk exposures over time, future returns to those exposures are not predictable based on recent returns. Therefore, investors should analyze risk exposures but avoid chasing recent returns in factors.

Question 4

How did the study suggest investors could improve their capital allocation decisions?

Answer 4

The study suggests that investors should employ more sophisticated models to separate traditional and exotic risks when allocating capital. This approach would help investors differentiate between cheap mutual funds or ETFs, which provide exposure to traditional factors, and hedge funds with exotic exposures.