Value Creation in the Hedge Fund Industry

We develop a novel approach to study the value-added in the hedge fund industry. This approach captures the large fund heterogeneity and controls for hedge fund complexities due to leverage and benchmarking. We find that most hedge funds create value using highly profitable strategies but are unscalable, which is a feature that prevents them from systemically dominating mutual funds. Hedge fund investors slowly improve their fund capital allocation over time, which suggests an impactful but noisy learning process. Despite these efforts, they extract a modest fraction of the total value-added. Overall, these findings are reasonably close to the equilibrium predictions of a rational model in which investors have limited bargaining power.