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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.

Suggested Citation

  • Bali, Turan G. & Brown, Stephen J. & Caglayan, Mustafa Onur, 2012. "Systematic risk and the cross section of hedge fund returns," Journal of Financial Economics, Elsevier, vol. 106(1), pages 114-131.
  • Handle: RePEc:eee:jfinec:v:106:y:2012:i:1:p:114-131 DOI: 10.1016/j.jfineco.2012.05.005
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    Cited by:

    1. Panopoulou, Ekaterini & Vrontos, Spyridon, 2015. "Hedge fund return predictability; To combine forecasts or combine information?," Journal of Banking & Finance, Elsevier, vol. 56(C), pages 103-122.
    2. Gong, Di & Wagner, Wolf, 2016. "Systemic risk-taking at banks: Evidence from the pricing of syndicated loans," CEPR Discussion Papers 11150, C.E.P.R. Discussion Papers.
    3. Subbiah, Mohan & Fabozzi, Frank J., 2016. "Hedge fund allocation: Evaluating parametric and nonparametric forecasts using alternative portfolio construction techniques," International Review of Financial Analysis, Elsevier, vol. 45(C), pages 189-201.
    4. Jung-Min KIM, 2015. "Failure Risk and the Cross-Section of Hedge Fund Returns," Working Papers 2015-13, Economic Research Institute, Bank of Korea.
    5. Huang, Ying Sophie & Chen, Carl R. & Kato, Isamu, 2017. "Different strokes by different folks: The dynamics of hedge fund systematic risk exposure and performance," International Review of Economics & Finance, Elsevier, vol. 48(C), pages 367-388.
    6. repec:eee:empfin:v:42:y:2017:i:c:p:109-130 is not listed on IDEAS
    7. 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.
    8. Bussière, Matthieu & Hoerova, Marie & Klaus, Benjamin, 2015. "Commonality in hedge fund returns: Driving factors and implications," Journal of Banking & Finance, Elsevier, vol. 54(C), pages 266-280.
    9. Bollen, Nicolas P. B., 2013. "Zero-R 2Hedge Funds and Market Neutrality," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 48(02), pages 519-547, April.
    10. Mathias S. Kruttli & Phillip J. Monin & Sumudu W. Watugala, 2017. "Investor Concentration, Flows, and Cash Holdings : Evidence from Hedge Funds," Finance and Economics Discussion Series 2017-121, Board of Governors of the Federal Reserve System (U.S.).
    11. Namvar, Ethan & Phillips, Blake & Pukthuanthong, Kuntara & Raghavendra Rau, P., 2016. "Do hedge funds dynamically manage systematic risk?," Journal of Banking & Finance, Elsevier, vol. 64(C), pages 1-15.
    12. Nucera, Federico & Valente, Giorgio, 2013. "Carry trades and the performance of currency hedge funds," Journal of International Money and Finance, Elsevier, vol. 33(C), pages 407-425.
    13. Agarwal, Vikas & Green, Tracy Clifton & Ren, Honglin, 2017. "Alpha or beta in the eye of the beholder: What drives hedge fund flows?," CFR Working Papers 15-08, University of Cologne, Centre for Financial Research (CFR).
    14. Mila Getmansky & Peter A. Lee & Andrew W. Lo, 2015. "Hedge Funds: A Dynamic Industry In Transition," NBER Working Papers 21449, National Bureau of Economic Research, Inc.
    15. repec:eee:glofin:v:33:y:2017:i:c:p:69-87 is not listed on IDEAS
    16. repec:eee:jfinec:v:125:y:2017:i:3:p:610-636 is not listed on IDEAS
    17. Bali, Turan G. & Brown, Stephen J. & Caglayan, Mustafa O., 2014. "Macroeconomic risk and hedge fund returns," Journal of Financial Economics, Elsevier, vol. 114(1), pages 1-19.
    18. Papageorgiou, Nicolas & Reeves, Jonathan J. & Xie, Xuan, 2016. "Betas and the myth of market neutrality," International Journal of Forecasting, Elsevier, vol. 32(2), pages 548-558.
    19. repec:spt:fininv:v:7:y:2018:i:1:f:7_1_1 is not listed on IDEAS

    More about this item

    Keywords

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

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General

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