What does the increased allocation to active funds hypothesis propose regarding hedge fund performance?

• A. It improves with heightened investor interest
• B. It remains unaffected by investor behavior
• C. It worsens due to investor trading decisions
• D. It benefits from increased competition

Answer: (C)

The increased allocation to active funds hypothesis suggests that as more capital flows into hedge funds, their performance can actually deteriorate. This occurs primarily due to the influence of investor behavior on trading decisions.

When more investors allocate capital to active funds, it can lead to crowded trades where too many investors chase the same opportunities. This increased demand can inflate asset prices or lead to irrational trading patterns, which may hinder the ability of fund managers to identify and capitalize on mispricings as effectively as before. Additionally, as fund sizes grow, managers may face limitations on their ability to deploy capital in a way that maintains alpha, especially in less liquid markets. Thus, while the expectation might be that more investor interest would enhance the potential for returns, the reality is that it can lead to negative consequences due to trading dynamics and overall competition for the same investment opportunities.

The other potential explanations for hedge fund performance in different scenarios do not capture the dynamics introduced by investor behavior and market impact revealed through the hypothesis.