The hedge fund industry has grown from $38 billion in 1990 to over $2 trillion in 2012. Presumably, much of this growth is driven by investors’ faith in hedge funds’ ability to generate abnormal returns via skilled trading. The view that these funds are skilled traders seems plausible. Compared to other institutional investors, hedge funds have greater flexibility in their investment choices, better liquidity management tools, and stronger performance incentives.

Hedge Fund

Talented Managers Attracted To Hedge Fund

Additionally, it is commonly believed that hedge funds are able to attract the most talented managers. For example, Mario Gabelli, a top mutual fund executive, admitted, “the brain drain to hedge funds from the traditional money management industry is real.”

Consistent with this view, the academic literature generally finds that the average hedge fund delivers net-of-fee alphas of roughly 3-5% (see, e.g., Ibbotson, Chen, and Zhu, 2011; Kosowski, Naik, and Teo, 2007; and Fung et al., 2008). Ultimately, the funds’ ability to generate abnormal returns must stem from their ability to profitably trade on mispriced securities.4 However, relatively little is known about how hedge funds exploit mispricing.

Mechanism Through Which Could Create Value

There are at least four mechanisms through which hedge funds could create value. First, funds may be skilled shareholder activists (Clifford 2008; Brav et al. 2008). Second, funds may have a comparative advantage in collecting and processing public information. Third, funds may profit through insider trading. Finally, hedge funds may outperform by providing liquidity to other investors who demand immediacy (Campbell, Grossman, and Wang, 1993).

Distinguishing among these explanations is challenging. Hedge funds are notoriously secretive about their investment strategies. Further, existing data on funds are typically limited to self-reported monthly returns or quarterly holdings, neither of which is well-suited for understanding the source of  funds’ trading profits.

How do Hedge Fund “Stars” Create Value?