Decreasing returns to scale and skill in hedge funds

In this paper, we investigate value creation by hedge funds using Berk and van Binsbergen's (2015) value-added. We find that, on average, hedge fund managers extract $0.76 million dollars per month from the market. We provide strong evidence of persistence in value creation by hedge fund managers. Of three skill indicators—skill ratio, fee ratio, and total compensation—we find that total compensation best identifies the skilled manager out-of-sample. Investors in value-creating funds benefit from a more favourable risk–return payoff. While hedge funds typically operate in a less competitive market than mutual funds, our findings suggest that incentive fees do not indicate greater skill. The value that hedge funds can extract from the market depends on both the profitability and scalability of their investment strategies.