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

We propose that higher skilled firms diversify in equilibrium even though managers exploit idiosyncratic performance shocks to time diversification moves. We formalize this intuition in a mistakefree equilibrium and test our predictions using a large panel dataset on the hedge fund industry 19772006. The results show that returns fall following new fund launches, but are 13 basis points per month higher in diversified firms compared to a matched control sample of focused firms. Consistent with the theory, the evidence suggests that both idiosyncratic performance shocks and systematic differences in skill influence diversification decisions. * We thank Margaret Kyle, Justin Miller, John Morgan, Gabriel Natividad, Amy Nguyen-Chyung, Santiago Oliveros, Robert Stambaugh, Nickolai Roussanov, Steve Tadelis, Oliver Williamson and participants at the CRES conference at Washington University, and seminars at the University of California Berkeley’s Haas School of Business, the Harvard Business School, and The Wharton School for helpful suggestions. We acknowledge thoughtful research assistance from Justin Tumlinson. Rawley is grateful for financial assistance from the Rodney L. White Center for Financial Research at the Wharton School.