Skill, Luck, and Reputation in Product Diversification Decisions: Evidence from the Hedge Fund Industry

Abstract: This paper examines how skill, luck and reputation influence firm product diversification decisions. We develop a model where skill and luck drive firm performance, which in turn determines reputation, and show that the propensity to engage in product diversification is increasing in firm reputation. However, conditional on current reputation, future expected reputation effects reduce the attractiveness of product diversification for lower ability firms. We test these predictions using a large panel dataset on the global hedge fund industry. Our key results show that within-fund changes in returns are negative following diversification, but post diversification returns are 15-20 basis points per month higher in multi-fund firms compared to a matched control sample of focused firms. We interpret the results as evidence that firms exploit asymmetric information about their own ability to time new product launches, yet, reputation effects limit product diversification opportunities for lower ability firms.