Preliminary version

This paper documents how the shape of the flow-performance relationship in the hedge fund industry varies across market conditions. Further, this is the first paper that establishes a link between the convexity of the flow-performance relation and implicit risk incentives of hedge fund managers. In a first stage, we employ a switching regression approach to explain quarterly hedge fund flows, based on defining two regimes where either inflows or outflows are dominating, combined with a flexible functional form for each of the equations, allowing for a nonlinear impact of past performance at different lags. We characterize the local and global convexities of the relationship by several measures and investigate how they vary over time. In a second stage, we find evidence of significant risk-shifting behaviour of hedge fund managers in response to changes over time and in the cross section in convex payoffs implied by the flow-performance relation. Risk adjustment ratios (RAR) increase by 17 % in high-flows periods with respect to low-flows periods in response to a three-fold increase in convexity ratios for the bottom convexity quintile. In the cross-section, the differences in risk adjustment ratios between the top and botto