June 25, 2013
Abstract:
I use transaction-level data to investigate the magnitude and source of hedge funds' equity trading profits. Bootstrap simulations indicate that the trading profits of the top 10% of hedge funds cannot be explained by luck. Similarly, superior performance persists. Outperforming hedge funds tend to be short-term contrarians with small price impacts, and their profits are concentrated over short holding periods and in their more contrarian trades. Further, I find that performance persistence is significantly stronger for contrarian funds with small price impacts. My findings suggest that liquidity provision is an important channel through which outperforming hedge funds persistently create value.
...MORE (61 page PDF)...There are at least four mechanisms through which hedge funds could create value. First, hedge funds may be skilled shareholder activists (Clifford 2008; Brav et al. 2008). Second, hedge funds may have a comparative advantage in collecting and processing public information. Third, hedge 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)....
