Which way does the arrow point? Fund closures and returns

Question

An investor notices that hedge funds which closed to new money tended to have excellent returns in the years before closing, and concludes that closing a fund to new investors boosts its performance.

Give the more plausible causal direction and explain why the naive reading is backwards.

Accepted Answer

This is reverse causation. The likelier story is strong returns cause the closure, not the closure causing strong returns. A fund that performs well attracts inflows and grows; managers then close it to new money to protect the strategy's capacity before size erodes the edge. So the great returns come first and trigger the decision to close. The correlation reflects successful funds choosing to cap their size, with the arrow running performance to closure, opposite to the investor's claim. The subtlety. Closing is a symptom of past success and a defense against future capacity problems, not a…

Which way does the arrow point? Fund closures and returns

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