Can Capacity Constraint Explain Introduction of New Hedge Funds?

In this paper we test the idea that hedge funds‟ capacity constraints may play a significant role on the decision of fund families to open a new hedge fund. Our empirical analysis shows that fund families‟ propensity to open new funds increases with degree of capacity constraint faced by existing funds of the families. We argue that hedge fund families face diseconomies of scale because of the non scalability of their investment strategies and as their existing funds approach the critical size, fund families prefer opening a new hedge fund rather than allowing the existing funds to grow. We find that the strategy of starting new hedge funds to divert fund flows from an existing fund works well as fund flows to the existing fund decreases, and that the introduction of new funds also lead to an improvement in the performance of the existing funds of the same family. Preliminary Draft: May, 2011 __________________________________ Acknowledgements: We thank Greg Gregoriau for playing an instrumental role in providing the data used in this study and for educating us on the hedge fund industry overall. We are responsible for any remaining errors in the paper.