Indirect effects of flow-performance sensitivity on fund performance

Abstract

This study examines changes in the flow-performance sensitivity (FPS) among funds of hedge funds (FoHFs) after the global financial crisis and the Madoff scandal. We also explore whether these changes in FPS affect fund performance. After the crisis, investors in FoHFs began to prioritize fund reliability over fund performance, particularly in the case of young and small FoHFs with limited track records and investor bases. As a result, the overall FPS of FoHFs decreased in the post-crisis period, primarily due to decreases in FPS among young and small FoHFs. Furthermore, we observe that funds with lower sensitivity exhibit significantly worse performance than those with higher sensitivity. These results are robust to both risk-adjusted and relative performance measures. Our findings suggest that the performance-based incentive structure prevalent in the hedge fund industry imperfectly aligns fund managers’ interests with those of investors and that FPS plays a positive role in driving fund performance.