Skill, Luck and the Multiproduct Firm: Evidence from Hedge Funds

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Is it more important for hedge fund managers to be lucky or skilled when expanding to offer new products?

How about both?

In "Skill, Luck and the Multiproduct Firm: Evidence from Hedge Funds," Wharton management professor Evan Rawley and Rui J.P. de Figueiredo, Jr., of the University of California Berkeley, explore how strong returns from existing hedge funds drive launches of new products. They observe that, while many funds post strong returns at some point in time, the "lucky" funds separate themselves from the "skilled" funds based on their diversification choices immediately afterwards.

The fee structure of hedge funds drives them to launch new funds; more expansive is always better when working off a percentage of gross returns without "clawbacks." But fund managers understand that launching new funds can reveal their weaknesses as money managers. So while the authors show that most managers wait until they generate strong returns to launch a new fund, investors have good reason not to worry that a fund contacting them for money is basing the pitch on a single fluke period. The poor manager knows he or she cannot sustain those strong returns, and that opening a new fund presents a tremendous risk to his or her reputation, Rawley notes. Meanwhile, the skilled manager knows that he or she can benefit from diversification into a new fund and keep that reputation intact.

To demonstrate this effect, Rawley and de Figueiredo followed a select sample of 1,353 funds from 1994 to 2006. While 676 of these funds remained "focused," the remainder launched a new fund. The study finds that the new funds boasted returns of six basis points higher per month per unit of risk compared to focused funds; the higher returns suggest superior fund management.

But that does not necessarily mean that only the weaker funds chose to stay focused. "There are some good firms that want to remain focused, and there are some bad, lucky firms that end up diversifying," Rawley says, meaning that a lack of diversification might not be sufficient grounds to reject investing in a hedge fund. Specific factors, like the existing fund's clients and the cost of launching a new fund, may prevent "skilled" funds from branching out.

In addition, there are some limitations to applying this theory outside of the hedge fund industry, according to Rawley. Hedge fund managers usually have their own wealth in the fund, making them averse to the short-term versus long-term tradeoffs that industrial managers might make. Hedge funds must also go to capital markets to fund expansions, while companies in the "real economy" might fund expansions with money from their own balance sheets. But Rawley suggests that the study may help other researchers or industry analysts to better understand the role of luck and skill in other business contexts. "We show that both of these effects are important. You can't just talk about one in isolation."