Net Inflows and Time-Varying Alphas: The Case of Hedge Funds

The growth in the size of the hedge funds industry has led some in-vestors to worry about a decline in alphas, associated with reduced arbitrage opportunities in international financial markets. We introduce a multivariate components model for returns and net relative inflows into hedge funds, accounting for time-varying market premia. We estimate alpha as an unobserved component variable of the econometric model. We then assess whether several categories of hedge funds do produce extra profits and whether the flows of funds into the industry are dynamically related to returns. Our results point to a positive correlation between past returns and future flows, while the evidence concerning the linkage between past flows and future returns is mixed. However, we do not find any structural decline in alpha for most hedge fund categories.