The Effect of Investment Constraints on Hedge Fund Investor Returns

The aim of this paper is to examine the effect of frictions and real-world investment constraints on the returns that investors can earn from investing in hedge funds. We contribute to the existing literature by accounting for share restrictions, minimum diversification requirements and fund size restrictions that are commonly used by institutional investors. We show that the size-performance relationship is positive (negative) when past (future) performance is used. Evidence of performance persistence is reduced significantly when fund size and share restrictions such as notice, redemption and lockup period are incorporated into rebalancing rules. We test several hypotheses regarding the economic mechanism that underlies the size-performance relationship. We find empirical support for theoretical models based on decreasing returns to scale as well as managers responding optimally to fee incentives. The findings have significant implications for hedge fund investors since they caution against chasing performance in hedge funds and within the billion dollar club of hedge funds, in particular