Asset Allocation Dynamics in the Hedge Fund Industry

Li Cai and Bing Liang

Volume 10, Number 2, Second Quarter 2012

This paper examines asset allocation dynamics of hedge funds through conducting optimal change point test on an asset class factor model. Based on the average F-test and the Bayesian Information Criterion (BIC), we find that more dynamic hedge funds exhibit significantly better quality than less dynamic funds, signaled by lower return volatility, stricter share restrictions, and high water mark provision. In particular, a higher degree of dynamics is shown to be associated with better risk-adjusted performance at the individual fund level. We find that the degree of a fund’s dynamics is closely related to share restrictions. However, the outperformance of highly dynamic funds is robust even after controlling for share restrictions. Sub-period analysis suggests that the superiority of asset allocation dynamics is mostly driven by performance during earlier time periods before the peak of the technology bubble. Fund flow analysis suggests that abnormal returns in the hedge fund industry are diminishing as capital flows in and arbitrage opportunities are not infinitely exploitable.