Returns to Scale in the Hedge Fund Industry Restricted; Files Only

Zotovic, Stefan (Spring 2019)

Permanent URL: https://etd.library.emory.edu/concern/etds/9593tv964?locale=en
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Abstract

Financial economists and investors alike have long tried to understand the driving forces behind hedge fund performance. Progress has been made in, for example, distilling manager skill from market and other risk exposures. However, one key question has been left unanswered, or rather, poorly answered: Is the size of a fund informative in predicting its future returns? In the literature, there have been numerous and contradictory attempts to pin down this scale effect. However, econometric bias and uncertainty in the methodologies have interfered with the efforts. Armed with an enhanced recursive demeaning methodology, we find significant evidence of decreasing returns to scale at the fund level which set in after an optimal size. Importantly, we show that it is necessary to account for nonlinearity in the fund size effect. Next, we add to the literature by showing that there are no significant decreasing returns to scale at the industry level. Moreover, the fund-level returns to scale are robust to inclusions of industry size. We reformulate this result as an investment strategy by developing a method to sort funds into those experiencing increasing returns to scale (IRS) and those experiencing decreasing returns to scale (DRS). Then we build a portfolio that is long IRS funds and short DRS funds and show that significant positive returns can be generated by capitalizing on the size-performance relationship. 

Table of Contents

1.    Introduction ........................................................................................1

2.    Data ....................................................................................................7

2.1. Data Cleaning .....................................................................................7

2.2. Size Proxies .......................................................................................10

2.3. Deriving Performance Measures: Gross Return .................................10

2.4  Deriving Performance Measures: Risk-Adjusted Alphas ....................12

3.    Methodology ......................................................................................14

3.1. OLS Regression ..................................................................................14

3.2. Fund Fixed Effects .............................................................................15

3.3. Recursive Demeaning ........................................................................19

3.4. Characterizing Funds as IRS or DRS ..................................................21

4.    Empirical Results ...............................................................................22

4.1. Fund-Level Returns to Scale ..............................................................22

4.2. Industry-Level Returns to Scale .........................................................26

4.3. Scale-Based Investment Strategy .......................................................27

5. Conclusion ............................................................................................29

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