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Systematic risk and the cross section of hedge fund returns

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  • Bali, Turan G.
  • Brown, Stephen J.
  • Caglayan, Mustafa Onur

Abstract

This paper investigates the extent to which market risk, residual risk, and tail risk explain the cross-sectional dispersion in hedge fund returns. The paper introduces a comprehensive measure of systematic risk (SR) for individual hedge funds by breaking up total risk into systematic and fund-specific or residual risk components. Contrary to the popular understanding that hedge funds are market neutral, we find that systematic risk is a highly significant factor explaining the dispersion of cross-sectional returns while at the same time measures of residual risk and tail risk seem to have little explanatory power. Funds in the highest SR quintile generate 6% more average annual returns compared with funds in the lowest SR quintile. After controlling for a large set of fund characteristics and risk factors, systematic risk remains positive and highly significant, whereas the relation between residual risk and future fund returns continues to be insignificant. Hence, systematic risk is a powerful determinant of the cross-sectional differences in hedge fund returns.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 106 (2012)
Issue (Month): 1 ()
Pages: 114-131

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Handle: RePEc:eee:jfinec:v:106:y:2012:i:1:p:114-131

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Web page: http://www.elsevier.com/locate/inca/505576

Related research

Keywords: Hedge funds; Systematic risk; Residual risk; Return predictability;

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References

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Cited by:
  1. Bussière, Matthieu & Hoerova, Marie & Klaus, Benjamin, 2014. "Commonality in hedge fund returns: driving factors and implications," Working Paper Series 1658, European Central Bank.
  2. Huang, Shiyang & Qiu, Zhigang & Shang, Qi & Tang, Ke, 2013. "Asset pricing with heterogeneous beliefs and relative performance," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4107-4119.

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