The Life Cycle of Hedge Funds

Abstract

Hedge fund managers proclaim that they predominantly use investment strategies that generate profit from misvalued market instruments. Regarding efficient market theories, hedge funds use market price anomalies and hence serve to increase market efficiency. Especially with arbitrage-based strategies, however, in highly competitive markets it is possible that excess returns will vanish over time because other investment managers will "jump on the bandwagon," and trade similar inefficiencies, thus diminishing risk premiums. Hedge fund excess returns will naturally decrease over time. The thesis that hedge funds develop according to this pattern is called the "life cycle theory of hedge funds." This article empirically investigates the life cycle theory based on an extensive database of 1.433 hedge funds for the period January 1996 until May 2006. We verify that hedge funds indeed follow a life cycle.

Keywords: hedge funds, omega, life cycle theory

JEL Classification: G2, G12, G31