We examine whether the increase in the flow of capital to hedge funds over the period 1994–2005 had a negative impact on performance. More specifically, we study the relative performance of small versus large funds for each of the hedge fund strategies. Our results indicate that on an absolute return basis, small funds outperform large funds. On a risk-adjusted return basis, however, we find that large funds outperform small funds, and that large funds are also shown to hold less liquid assets and take on less systematic and idiosyncratic risk than small funds. Further, funds that experience positive liquidity shocks generally outperform those that experience negative liquidity shocks. We also find evidence that hedge fund managers that are aggressive in dealing with liquidity shocks perform better than hedge fund managers that are conservative in dealing with liquidity shocks.

Each year, millions of dollars are reported lost due to terrorist attacks around the world. In this paper, we conduct a systematic examination of the impact of terrorist attacks on financial markets. We specifically explore the relationship between world stock market indices and large-scale terrorist incidents. We consider sixteen incidents outside the U.S. and thirty-three incidents in the U.S. We use several indices in our analysis, including the S&P 500, the 10-year US Treasury bond yield, gold prices, and several other domestic and international stock market indices. Given the physical asset losses and the psychological impact on citizens, our expectation was to see a strong correlation between terrorist incidents and financial market valuations. However, to our surprise, with the exception of the September 11, 2001 terrorist attacks, our results show that acts of terrorism do not have a significant or lasting economic effect on stock and bond market returns. Contrary to our starting hypothesis, we find no evidence of ‘flight to safety’ behavior in any of the markets.

We provide evidence of a significant relation between diversification and performance in the hedge fund industry. Measuring diversification across four distinct dimensions, we find a significant positive relation between hedge fund performance and diversification across sectors and asset classes. We show that on a risk adjusted basis, hedge funds that diversify across sectors and asset classes outperform other funds by an average of 1.1% per year. However, diversification across styles and geographies exhibits a significant negative association with hedge fund returns. Funds that diversify across styles and geographies underperform other funds by an average of 1% per year. For fund of hedge funds, we find a significant positive relation between performance and diversification across sectors. However, diversifying across asset classes and geographies is found to exhibit a negative relation with fund performance. Finally, we find that the motive to engage in diversification is consistent with managerial incentive structure in the hedge fund industry.